Tuesday, May 25, 2010

Preventing the Civil War

My younger son has been reading Civil War history, starting with Jeff Hummel's book. A few days ago at dinner, we got into a discussion of possiblities for alternate history, starting with the observation that both sides greatly underestimated how bad the war was going to be. Bill cited Hummel's estimate that the cost to the North alone would have been enough to buy every slave in the south and provide each with thirty acres and a mule. What if they had known?

Imagine that someone in our future is equipped with a device capable of delivering packages to the past. He makes a list of thirty or forty of the most influential people in the U.S. as of (say) the 1850's, prepares for each a package of history books, and delivers the package to the recipient's desk a week or two before some prominent natural event, such as an earthquake or eruption, is due to occur.

Each package includes a dozen identical color photographs and a cover letter. The letter predicts in detail the event about to occur and explains that the package is being sent in the hope of preventing a very bloody war. The photographs could not have been produced with mid-19th century technology; the hope is that they plus the prediction will be enough to persuade at least some of the recipients that the package really is from the future. What happens?

Bill's guess was that the deep South states would respond by immediately seceding. My reaction—not inconsistent with his—was that what the intervention has created is a high stakes game of Chicken. Leaders in the North can tell those in the South that they might as well surrender now, since the alternative is a long and bloody war that they will lose. Leaders in the South can argue in response that the North, knowing what the cost of the war will be, will have to back down and let them go.

It could make the plot of an interesting novel. If I were writing it—not likely to happen—I would be inclined to show the intervenors from the future as naive do-gooders who take it for granted that if only both sides had known, the war would of course be averted. The recipients are both more realistic and more sophisticated; each sees both his new information and his knowledge that others have the same information as merely additional elements in the complex political game already ongoing.

One question is how long before the war the intervention happens. Another is whether the recipients attempt to make their new knowledge public, and if so how many people believe them. Readers are invited to indulge their own imagination.

Cell Phone Catch 22

I had decided to switch to Verizon, getting the HTC Incredible for me, two other phones for other family members. Buying the phones from Amazon is considerably less expensive than buying them directly from Verizon, so that was my plan.

Until I discovered two related problems. The first is that the Incredible is on back order—whether from Amazon or Verizon it is expected to take at least a month. The second was that each phone's account starts when the phone gets to me. Turning it on is necessary to transfer the number, but billing starts immediately.

So if I order three phones and two are sent immediately while mine is delayed a month or two, I will be a customer of both Verizon and T-Mobile and paying both. According to the Verizon representative I talked with over the phone, there is no way of instructing them that I don't want the service plan to start until I have all three phones. It's possible that I could solve the problem by instructing Amazon to send the three phones together, but without confirming that with Amazon it seems a bit risky—and Amazon, so far as I can tell, provides neither telephone nor email access for people who have questions.

So it looks as though we are remaining with T-Mobile until the Incredible is actually available. The silver lining to the cloud is that I get to continue online window shopping of new Android phones. If the rumored Motorola Shadow comes out before the Incredible actually becomes available ... .

Thursday, May 20, 2010

Maybe He Really is a Liberal

"One: we will repeal all of the intrusive and unnecessary laws that inhibit your freedom. "

A recent speech by Nick Clegg, deputy prime minister of the U.K. and leader of the liberal democrats, suggests that he may actually be a liberal—in the old sense of the word. If his deeds match his words, it could be very good news.

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I'm a liberal.

My starting point is always optimism about people.

The view that most people, most of the time, will make the right decisions for themselves and their families.

That you know better than I do about how to run your life, your community, the services you use.


Wednesday, May 19, 2010

Antibiotic Resistance, Exernalities, A Market Solution?

A recent post to this blog raises the issue of externalities associated with the use of antibiotics. The more an antibiotic is used, the greater the selective pressure in favor of pathogens resistant to it. Hence my use of an antibiotic may impose externalities on other people by making the drug less effective for them, which looks like an argument for legal restrictions on antibiotic use.

There is, however, a market solution to this problem, provided that two conditions hold. The first is that the effect is specific to a particular antibiotic—use of antibiotic A does not increase resistance to antibiotic B. The second is that the antibiotic is patented.

If both conditions hold, the apparent externality is internalized by the patent holder. The more doses of the antibiotic he sells the less effective it becomes, hence the lower the price he can get people to pay for additional doses. So it is in his interest to charge more and sell less than it would be if there were no externality. As in other cases of monopoly (absent perfect price discrimination), the result is not perfectly efficient, economically speaking. But it does convert the externality into a cost of production.

How nearly the first condition holds in practice I do not know; perhaps some readers of this blog can tell me. So far as the second condition is concerned, the obvious problem is the limited duration of patent protection. While the patent is in force, a profit maximizing monopolist will treat increased resistance to the drug during the rest of the patent term as an ordinary cost but ignore or discount any effects thereafter. If, after the patent expires, the market becomes competitive, each firm will treat as an internal cost only effects on the value of what it sells, not effects on the value of what its competitors sell. Hence the result is only imperfectly efficient—how imperfectly depends on how the useful life of a new drug compares to the term of patent protection.

But then, perfectly efficient outcomes, whether through the private or political market, are rarely an option.

Tuesday, May 18, 2010

Robert Frank Responds to Me Responding to ...

[Robert Frank offers what will I think be the final post in our exchange. I agree with much of it, including his praise of the beauties of Ithaca. One of his points—that the rich can benefit from the existence of the poor—is one I already made in the post he is responding to. I do not think, however, that what he says here provides much support for the arguments of his NYT piece. Readers will have to decide for themselves whether they agree.]
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David’s thought experiment about the consequences of adding a million millionaires to an existing society promises to advance our discussion. I share his view that existing members of society would benefit from the presence of the new group in many important ways. But not in all ways.

The relevant issues are similar to those that bear on the question of whether someone with an annual income of $30,000 would be better off today than having that same real income in the United States 200 years ago. Someone with that salary back then would of course have been one of the richest members of society; but the same salary today would fall well below the median.

Some researchers have argued that once society’s absolute per-capita income rises beyond even a small fraction of today’s level, further economic growth does not increase well-being. On that view, it would clearly be better to earn $30,000 in 1810 than to earn the same amount today. But as I have argued elsewhere, absolute income gains confer many important advantages and will continue to do so, even if those advantages go unrecorded in conventional surveys of well-being. If you had a toothache, for example, or a child with bacterial pneumonia, you’d much rather have access to today’s remedies than to 1810’s. And many now-fatal illnesses will be someday be cured as a result of further income growth.

Even so, there are other aspects of life that most people would find more attractive on a $30,000 salary in 1810. If you wanted a house with a view, for instance, you’d be able to afford one, whereas such a house would be far beyond your reach today. More telling, relative income has always been an important factor in mate selection, as David acknowledges. If you were hoping to marry up, your chances would be much better on a $30,000 salary in 1810 than on that same salary today.

If I were making the choice, I’d find the attractions of living in today’s wealthier society sufficient to outweigh the disadvantages of having lower relative income. I’m confident that David would make the same choice. But that does not mean that having low relative income is without cost. And it certainly does not contradict my claim that having high relative income confers important instrumental advantages, quite apart from whatever purely psychological benefits might accompany high rank.

Contemporary examples of the issues we’ve been discussing are also on clear display in the lives of people in Upstate New York. Although most of this region is economically depressed, there remain isolated pockets of prosperity. Ithaca, where I have lived and worked for almost 40 years, is one. It has prospered largely because it is home to both Cornell University and Ithaca College. Other similarly situated small cities nearby are struggling from a steady decline of manufacturing employment over the past several decades. Unlike those cities, Ithaca has great public schools, a long list of good restaurants, a vibrant theater and music scene, and an abundant supply of well-maintained turn-of-the century houses. It also overlooks the scenic beauty of glacially carved Cayuga Lake and is surrounded by numerous parks with dramatic waterfalls and hiking trails. The incomes and other characteristics of the talented people attracted by Ithaca’s universities explain why the city’s built environment and cultural amenities dominate those of otherwise similar cities in the region. The choice between living in Ithaca or, say, a city like Utica, would be a no-brainer for someone like David or me.

But although the presence of people like us creates many tangible benefits for Ithaca’s low-income residents, it also imposes nontrivial costs on them. Because housing prices in Ithaca are so much higher than in other cities in the region, for example, Cornell’s maintenance staff typically find it difficult to find affordable living space anywhere near the city. Many endure daily commutes of 40 miles and more.

Again, this does not mean that Ithaca is a worse place for low-income people than Utica is. On the contrary, the fact that low-income residents here could have moved to Utica but chose not to suggests that they find the Ithaca environment more attractive on balance. But nor should we conclude that all low-income persons would find Ithaca’s environment compellingly more attractive. After all, there are many thousands of low-income people in the region who could have moved here yet chose not to. What is clear, in any event, is that low-income persons in Ithaca experience many costs that they would not have experienced in Utica. Those costs are mitigated in part, but only in part, by the fact that our local tax and expenditure systems are somewhat more progressive than those of other cities in the region. This strikes me as being a fair reflection of the benefits and burdens experienced by different income groups here.

David is also correct that there are enormous economies of scale and scope at the society level. On this point, it is instructive to consider a simple variant of his thought experiment—namely, to imagine a society consisting ONLY of a million millionaires. The wealthiest Americans today show little interest in laundering shirts, teaching seventh graders, fighting fires, stocking grocery shelves, collecting garbage, mowing lawns, or delivering packages. Who would perform these tasks in a society composed only of very wealthy members? The poor benefit from the rich, yes, but the rich also benefit from the poor in ways that transcend feelings about rank per se. In short, everyone benefits from social institutions that make membership in society attractive to as many people as possible.

Needless to say, the mere fact that larger societies generate a larger per-capita economic surplus does not eliminate disputes over how any given surplus should be divided. It is no surprise, then, that top earners often lobby against higher taxes while those who earn least lobby for higher transfers. But those self-interested claims should not prevent us from trying to understand the deeper functions of taxes and transfers.

Compelling evidence suggests that the implicit progressive tax observed in every private pay scheme helps enable heterogeneous work groups to form and remain stable. I have argued that the transfer schemes embedded in every tax system on the planet help foster social cohesion in a closely analogous way. In this sense, they are consistent with Ronald Coase’s observation that the best social institutions are those that most closely mimic the ones that well-informed individuals would have agreed to in the absence of transaction costs.

Following Arguments Where They Lead

In my recent exchange with Robert Frank, I suggested that his view of schooling has important implications for government policy. If, as he argues, schooling is largely or entirely a positional good, something where what matters to the individual is not how good his education is in absolute terms but how it compares with other people's education, one implication is that we are spending far too much on it. The benefit I get from attending Harvard comes mostly, on this view, at the expense of other people who don't attend Harvard and as a result lose out to me in the later competition for jobs, mates, and status.

It follows that the social benefit—individual benefit summed over everyone—of my attending Harvard is much less than the private benefit, hence that individuals will be willing to spend much more on schooling than it is really worth. Putting it differently, it implies that each person's expenditure on schooling imposes negative externalities on other people. Frank appears to believe that this is true not only of money spent on going to Harvard but on the money spent by well off suburban taxpayers on the public schools that their children attend.

The usual view of economists is that acts imposing negative externalities ought to be discouraged, perhaps by taxing them. Schooling, however, is subsidized on an enormous scale, at both the K-12 level and above. So I asked Frank whether, on the basis of his expressed views, he would favor abolishing subsidies to schooling and taxing it instead. He never answered the question, perhaps because he viewed it as a digression from our central argument.

His failure to answer it raises a more general issue, not limited to Robert Frank or even to economists who share his political views. To what extent are they—I really mean we—willing to follow out the implications of our arguments when they lead to political conclusion we don't like?

Nuclear power is the one source of electric power that does not put carbon dioxide into the atmosphere and can be expanded more or less without limit—at a cost not wildly above the cost of power from fossil fuel. That ought to make it very attractive to those who believe that we face a threat of catastrophic proportions from global warming. Some environmentalists agree—most, at least so far as I can judge, do not. Similarly for the idea of geoengineering, holding the earth's temperature down by large scale projects to reduce the amount of sunlight the earth absorbs or to increase absorption of carbon dioxide, perhaps by fertilizing aquatic algae. In each case, there are undoubtedly arguments against as well as arguments for. But the arguments for do not seem to get much attention from those who, on the basis of their expressed views, ought to find them of great interest.

For libertarians, especially libertarian economists, a similar problem is raised by the issues grouped under the label of market failure—situations where individual rationality fails to lead to group rationality. Standard examples include public goods, externalities, adverse selection and private monopoly. In each case, good economic arguments can be made for the claim that interventions by government can lead to an improved outcome. Just as in the environmental case, the arguments are not conclusive; one can accept their validity while offering reasons to reject the conclusion (links to two different talks). But that approach is very different from the attempt to deny or evade the straightforward economic arguments in favor of intervention—as I believe some libertarian economists do. Libertarians who are not economists face a similar set of problems in justifying existing property holdings, many of which were not obtained by the means that libertarian political philosophy, going back to Locke, regards as legitimate.

Readers are invited to submit other examples—ideally ones associated with political positions they are sympathetic to.

Robert Frank and Libertarian Beliefs

My exchange with Robert Frank over his NYT piece seems to have come to at least a temporary halt. Unless he is going to concede that I am right or I am going to concede that he is, neither of which seems likely any time soon, there doesn't seem to be a lot more to say—although if he wants to respond to my most recent post in the series he is of course welcome to do so.

I thought, however, that it would be worth exploring a different feature of his argument—his view of what libertarians believe, offered as part of his argument for why libertarians ought to support governmental income redistribution. Frank writes:

"Society’s income distribution, [libertarians] argue, should reflect as closely as possible what people would earn in unregulated private markets."

Off hand, I cannot remember ever hearing a libertarian make that argument. A better version, later in the piece, is:

"Enlightened libertarians believe that the best social institutions mimic the agreements people would have negotiated among themselves, if free exchange had been practical."

Libertarians differ widely among themselves on both the basis for views and their implications, so the quote is probably true of some libertarians and certainly false of others—unless it is taken to exclude as unenlightened any libertarian who disagrees with it. But it is worth asking to what degree Frank is correctly describing the implications of the more common grounds for libertarian beliefs. Consider three different alternatives, corresponding to three common approaches to political philosophy.

1. Natural Rights: Probably the most popular position among the hard core of self-identified libertarians, some of whom make opposition to the initiation of force the defining characteristic of libertarianism. For most or all of them, both of Frank's statements are false. Following arguments along the lines of Robert Nozick's distinction between desert and entitlement, they hold that what matters is not what you end up with but how you got it. Whether or not the rich would have willingly given money to the poor in a zero transaction cost world is irrelevant to the legitimacy of coerced transfers by the state.

2. Social Contract: The contract is a metaphorical one. What people would have agreed to if ... is a common basis for deducing it, which makes this a plausible basis from which to defend the position Frank is arguing for. The only problem is that it is not a position popular with self-identified libertarians, few of whom are Rawlsians.

3. Consequentialism: The argument is that libertarian institutions lead to results that most people would prefer to the results of alternative institutions. This is the position I have usually argued from; while I have some sympathy with the moral intuitions underlying the natural rights position I lack arguments to support those intuitions, so prefer to take other people's objectives as given and argue that my preferred institutions would better achieve them. Utilitarianism is one version of consequentialism, but not the only possible one.

From a consequentialist standpoint, Frank's position is at least plausible—how plausible depending on the degree to which one believes that free exchange in a zero transaction cost world would lead to the optimal consequences. It is worth noting, however, that there is no reason to expect it to lead to a utilitarian optimum, for reasons having to do with the difference between economic efficiency and maximum utility.

So far I have been considering the views of self-identified libertarians. The label may also be applied to the much larger number of people, perhaps as many as ten or twenty percent of the population, who support some increase in individual liberty and reduction in government power in both social and economic contexts. I expect that many of them would be sympathetic to the view that Frank expresses but that few would take it as an adequate definition of their position.

I do not know if Robert Frank, in writing what I quoted above, was thinking of statements of principle made by specific libertarians. If he is reading this, he may want to provide examples. My own feeling is that, while many libertarians would agree that his claim about what perfectly functioning markets would produce, if true, would provide some defense for government redistribution, few would regard it as a conclusive, or even adequate, defense—and that, of those few, most would be economists.

Will Incumbent Losses Now Help the Democrats in November?

I've been seeing a lot of news stories on incumbent politicians who either have decided not to run for reelection or are at risk of losing in their party's primary. Many such stories emphasize the anti-incumbent mood of the electorate, linking the defeat of incumbents in the primaries to a possible Republican win in the election.

One point I have not seen discussed is the possibility that, for the Democrats, incumbent losses in primaries may be a plus in the election. After all, if the nominee is someone new to national politics who has defeated a long time incumbent, he can run as the new broom that sweeps clean—even if he happens to be running under the label of the party that currently holds the White House and both houses of Congress.

Friday, May 14, 2010

Is Boycotting Arizona Unconstitutional?

Various cities have announced plans to boycott the state of Arizona, in one way or another, in order to protest its immigration policy. One question I have not seen discussed is whether such boycotts raise constitutional issues. In the U.S. system, cities and counties are, legally speaking, creations of the states that contain them. It would seem to follow that actions of, say, the city of San Francisco count as actions of the state of California. I am not a constitutional scholar, but it is my understanding that the Constitution does not permit states to impose tariffs or similar restrictions on trade with other states.

A quick glance through the document finds that:

"The Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States."

"No Tax or Duty shall be laid on Articles exported from any State."

"No Preference shall be given by any Regulation of Commerce or Revenue to the Ports of one State over those of another: nor shall Vessels bound to, or from, one State, be obliged to enter, clear, or pay Duties in another."

I am not sure whether any of those, or something else I missed, has the implication I described, although the last one comes close if "ports" is broadly defined.

If I am correct, would a state whose officials promoted a boycott of another state be in violation?

Thursday, May 13, 2010

My Response to Robert Frank's ...

Reading Robert Frank’s most recent post, I have the impression that he is puzzled and frustrated by my failure to be convinced by his obviously correct arguments for his position. If so, our feelings are similar, since I remain puzzled as to why, after I have pointed out the gaping errors in his argument, he continues to repeat them. Instead of making another attempt at a point by point response, I am going to try to step back, summarize his argument as I understand it, and try to show what is wrong with it. That should give him an opportunity either to understand my argument, if the problem is that he doesn’t, or to point out how I am misunderstanding his.

The basic claim made in his Op-ed and defended in his posts here is that poorer people are worse off due to the existence of richer people, richer people better off due to the existence of poorer people, hence that it is only just to compensate the poorer at the expense of the richer. That claim has two parts. One is his old argument about the effects of the fact that humans care about (among other things) relative status. The other is the claim that, concern with relative status aside, the existence of rich people makes the less rich materially worse off and that the existence of poor people makes the less poor materially better off.

The first claim is, I think, correct; humans do care about relative status. But, as I pointed out in my initial post and as each of us has agreed since, those effects are local, hence provide no justification for income redistribution on a national scale. In his most recent post I think Robert Frank to some degree concedes that, referring to his own argument as “difficult-to-document claims of psychological damage used [caused?] by inequality,” and recasts the argument in terms of “concrete costs” due to a cascade of competitive expenditures, in effect substituting for his first claim a version of the second. Doing so makes the first half of the argument in his Op-ed, his old analysis of the effect of concern with status on wage differentials in the market, almost entirely irrelevant to the second half, his defense of governmental income transfers. Yet it was the first half which was supposed to persuade libertarians that they should approve of the transfers defended in the second, since they only reflected, on a larger scale, what would come out of voluntary interactions in a world without transaction costs.

It is the second claim that seems to me strikingly mistaken. He has now twice—in his most recent post and the one that preceded it—first agreed that what matters in health care is the absolute level and then proceeded to put his argument in terms of the relative level, not how good the health care is that someone can get but whether or not he can get “the best” health care.

Perhaps my point can be made clearer if I put it in terms of a comparison between two hypothetical societies which differ only in the number of wealthy inhabitants; the second consists of the first plus an additional million people, each with an income of a million dollars a year. Obviously, if they get that income by stealing it from everyone else, their presence makes other people worse off, but that is not Robert Frank’s argument. He started, after all, with an explanation of why the wages of more productive workers do not fully reflect their additional productivity. Hence I think I can fairly assume that each of those million gets his income by producing goods and services worth, to other members of the society, at least a million. The question is then whether people other than the million wealthy are worse off in the second society than in the first.

One of the things the additional people will spend their income on is medical services. Hence the second society will have more, and probably better, medical services than the second—more good hospitals, more highly trained surgeons, a larger quantity and probably a larger variety of medical drugs. We might quantify the effect by supposing that the first society has a million doctors whose skill ranges, on some metric, from one to ten, and the second adds to that an additional ten thousand whose skill ranges on the same metric from five to eleven—all of whom are providing their services exclusively to the additional wealthy people.

Robert Frank tells us, correctly, that “When a serious health problem strikes, a person wants the highest absolute quality of care possible, but because the quality and quantity of care are limited at any given moment, not everyone seriously ill patient can have the best. My claim, which is surely completely uncontroversial, is that someone with high social rank is more likely than others to get the best care.” That sounds as though it means that the addition of people of high social rank reduces the quality of medical care available to those of lower rank—but it doesn’t. In my example, constructed to simplify the argument but consistent with his view of the situation, it means that someone who before got medical care of quality ten is still getting medical care of quality ten. The reason he is no longer getting “the best care” is that there are now other people getting care of quality eleven.

Robert Frank conceded, two posts back, that what matters is the absolute level of medical care not the relative level. To complain that someone is no longer getting the best level with the implication that he is now worse off, when what has actually changed is not the medical care he can get but the care others can get, is to treat a relative change as if it were an absolute change. It is his failure to see that very simple point—now twice repeated—that makes me feel as frustrated at his responses as he appears to be at mine.

There is, I think, a second error embedded in what I just quoted, this time in the words “at any given moment.” If my additional million people, complete with their income and their demands for medical care, suddenly appeared in a society, and if none of them happened to be physicians, they would indeed bid existing medical services away from others.

But that is not what is happening, either in my hypothetical or in the real world that we have been arguing about. Putting the analysis in terms of “any given moment” implicitly converts the real economy, in which goods are produced as well as consumed, into the fixed pie economy that one can imagine existing at any single instant, with production frozen and consumers competing over already produced goods. That is a perspective popular with people making political arguments, especially ones in favor of income transfers, but a very odd one for an economist to adopt.

I have focused on medical care, but the same analysis applies to education. It is true that having gone to a better school makes you likely to be accepted into a better job. But the distribution of available jobs is not frozen any more than the distribution of available medical services; both reflect, among other things, the distribution of productive abilities in the society. If my additional million people spend part of their income on their children’s education the result will be more well educated people, hence more very productive people, hence more high paying jobs. The individual who before would have gotten the best job the firm offers at a salary of a hundred thousand a year now gets only the second best job the firm offers—at a salary of a hundred thousand a year. It is true that “persons of high social rank are more likely than others to be able to send their children to the best schools.” But the best schools are now better, as are the jobs available to the graduates of the best schools, so the graduate of what is now only the second best school need not be, in any material sense, worse off. Again there is a confusion, although a less obvious one, between relative and absolute.

In arguing that the poor are not made materially worse off by the existence of the rich I have understated my case. In material terms, Robert Frank’s account is not merely wrong, it is backwards. Not only do poor people not lose, materially speaking, from the existence of rich people, they can be expected, on average, to gain.

This is true for two reasons. One I already pointed out in my previous post. The production cost for some things—medical drugs are a particularly striking example—is in large part the cost of generating information. The more buyers that is divided among, the less the cost to each. The fact that some people are wealthy results in a larger demand for medical drugs, which makes any particular drug less expensive, as well as funding the development of additional drugs. That is a benefit to the poor as well as to the rich.

The second reason is a point underlying the principle of comparative advantage: we can gain more by exchange with people who are different from us than with people who are similar to us. I would have a hard time persuading any of my colleagues to mow my lawn at a price I would be willing to pay. The recent immigrants who in fact mow my lawn would have a hard time persuading any of their friends and relations to pay them a price for mowing a lawn that they would be willing to accept. I am better off by the existence of the immigrants and they by my existence—our different situations make possible exchanges to our mutual advantage. Generalize that and it follows that the rich are indeed made better off, as Robert Frank believes, by the existence of the poor—at least in the context of voluntary interaction on the market—but the poor are also better off by the existence of the rich.

Robert writes: “Unless David has new evidence that persons of low social rank have greater access to the best health care and greater access to the best educational opportunities, I hope he will abandon these objections.

Unless Robert has evidence that persons of low social rank have access to a worse quality of health care and education than they would if people of high social rank did not exist or had lower incomes than they do, I hope he will abandon arguments that hinge on the word “best,” and so depend on confusing relative with absolute outcomes.

Wednesday, May 12, 2010

Robert Frank's Reply to My Reply to ...

[Received from Robert Frank, and posted with his permission]

Many thanks to David for his spirited reply. In responding to it, I’ll begin with another attempt to clear up some issues I thought had been settled in our first exchange.

For example, David again spends considerable energy arguing that health care is not a positional good—that what matters primarily is its absolute quality, not its relative quality—and emphasizing that we can raise its absolute quality by devoting more resources to it. Well and good. But so what? As my original response to David’s comment made clear, I am well aware that the demand for health and safety is among the least positional of all demands. And I agree completely that the absolute quality of it is what matters. But those points do not challenge the fundamental claim on which my argument rests—namely, that high social rank has substantial instrumental value.

When a serious health problem strikes, a person wants the highest absolute quality of care possible, but because the quality and quantity of care are limited at any given moment, not everyone seriously ill patient can have the best. My claim, which is surely completely uncontroversial, is that someone with high social rank is more likely than others to get the best care.

Access to the best care is of course not the only reason that high social rank has instrumental value. It also commands access to the best education. In David’s response, he again devotes considerable energy trying to establish that the absolute quality of education matters. But here, too, I ask myself, why would anyone think I disagree? If everyone were better educated, our economy would be more productive. Our incomes would be higher, and that would be a good thing! In the 19th century, a family with five children typically saw several of them die before reaching their 10th birthday. That this no longer happens is primarily a consequence of the fact that our absolute incomes are so much higher now, which is in part a consequence of better education. So of course the absolute quality of education matters.

But the relative quality of education also matters. In modern labor markets, the absolute salary gap between the best-paying jobs and other jobs is larger than at any point in history, and there are almost always many more applicants for the top jobs than employers could possibly interview. Surely it is uncontroversial to note that educational credentials are one of the most important screens that employers use to whittle their applicant lists. For a candidate even to land an interview, his absolute educational quality must be high, yes. But that’s not enough. It must also compare favorably with that of other applicants. So unlike the health care domain, in which absolute quality is the main concern, the educational domain is one in which both absolute and relative quality matter. But here, too, the important point for my argument is that persons of high social rank are more likely than others to be able to send their children to the best schools. That point is completely uncontroversial.

The health and education domains are hardly the only ones in which high social rank has instrumental value. That value is the basis for my claim that in the libertarian’s ideal world of zero transaction costs, people would not be able to claim positions of high social rank for free. As in the analogous case of high-ranked positions in private work groups, they would command positive implicit prices.

David’s health care and education objections, as noted, seemed clearly settled in our original exchange. I am therefore puzzled by his decision to again make them the focal points of his critique. I have responded to these objections. Simply repeating them will not give them additional force. Unless David has new evidence that persons of low social rank have greater access to the best health care and greater access to the best educational opportunities, I hope he will abandon these objections.

He does raise another objection, however, that merits detailed consideration. He begins by conceding my claim that the interpersonal comparisons that really matter to people are those with others like themselves. That claim implies that the non-poor don’t gain self-esteem from the knowledge that others are poor. But that fact, David argues, destroys the rationale for my claim that high-ranked members of society are taxed to compensate the low-ranked members of society without whose presence high social rank would not exist. If the rich don’t benefit from comparisons with the poor, he asks, why should they be willing to compensate them for the burdens of low social rank?

This objection sounds much more promising. But it, too, falls short on closer inspection. I agree that high-ranked members of society receive no direct benefit from comparing themselves with the poor. Also true (though this may seem less obvious) is that the poor do not seem to suffer direct damage by comparing themselves to the rich. On the contrary, low-income people appear to have a vigorous appetite for media coverage of the lifestyles of the rich and famous.

But the poor are nonetheless adversely affected by indirect externalities spawned by expenditures by the wealthy. I refer to a process that I have elsewhere called “expenditure cascades.” The lion’s share of all income gains in recent decades have accrued to top earners, and their spending on housing and other goods has risen accordingly. Despite the finger-wagging of social critics, that’s hardly a moral indictment of the rich. All groups in society, after all, spend more when their incomes rise. Although there’s no evidence that the poor or middle class are upset by the bigger mansions at the top, those same mansions shift the frame of reference that defines acceptable housing for those just below the top, who travel in many of the same social circles. And so they, too, have built bigger, which has shifted the frame of reference for others just below them, and so on, in a cascade that extends all the way down the income ladder.

That cascade has raised the cost to poor and middle-income families of maintaining their places in the educational hierarchy. A good school, again, is one that compares favorably with other schools. To gain access to such a school, a family must bid for a house in the neighborhood that surrounds it, and that’s what has gotten more expensive. For example, in 2007 the median new house built in the United States had almost 50 percent more floor space than the corresponding house in 1980, notwithstanding the fact that median real household income had risen little during the intervening years. People could have abstained from trying to keep up with the housing expenditures of their peers, but that would have meant sending their children to worse schools than before.

In short, notwithstanding the fact that the most important interpersonal comparisons are local, the poor have experienced substantial costs because of the additional spending of the rich. Far more than difficult-to-document claims of psychological damage used by inequality, it is these concrete costs that constitute grounds for saying that in a world without transaction costs, high-ranked positions in the social hierarchy would not be available free of charge. The rich are not paying for the right to compare themselves directly to the poor. They are paying to maintain a social structure from which they benefit greatly.
Everyone gains, for example, from greater opportunities for specialization and exchange. But as international experience amply demonstrates, social stability cannot be taken for granted when income and wealth inequality grow beyond a certain point. Diverse societies are efficient, but will not remain stable unless the terms of the social contract are perceived as fair. And as every country on the planet has decided—implicitly or explicitly—part of such a contract entails income transfers from rich to poor.

To the libertarian’s objection that such transfers are morally unjust, I have argued that they are consistent with the libertarian dictum that the best social arrangements are those that mimic as closely as possible the arrangements people would have negotiated in a world of zero transaction costs. I continue to invite attempts to rebut that argument in its own terms.

Tuesday, May 11, 2010

My Response to Robert Frank's Reply

[I am quoting pieces of what Robert Frank wrote (in italics) and my responses. The full text of his response to my response to his op-ed is in the post before this.]

Robert Frank writes:

In my piece, for example, I claimed that high social rank has substantial instrumental value, observing that the highest-ranking members of society “know they will be able to send their children to the best schools and have access to the best health care. Low-ranking members enjoy no such confidence.” David disagrees, saying that this passage demonstrates my failure “to distinguish between absolute and relative values”: "Getting good health care,” he writes, “is very important to me, but its value does not depend, so far as I can judge by introspection, on other people having worse health care."

As I’ll argue in a moment, the failure to grasp the relevant distinction is his, not mine. He is correct, though, that demands for health and safety are among the least positional of all demands. Suppose, for example, that you ask someone to choose between two hypothetical worlds: World A, in which he has a 5 in 10,000 probability of dying on the job each year while the corresponding probability for other workers is 10 in 10,000; or World B, in which his annual probability of dying is 2 in 10,000 and the corresponding probability for others is 1 in 10,000. Almost everyone picks World B, the absolutely safe but relatively unsafe one.

But that fact has absolutely no bearing on my claim that persons of high social rank have greater access to the best health care. Resources are finite.

Finite but not fixed. Health care is a produced resource.

The most renowned practitioners cannot provide the most costly medical treatments to every seriously ill patient.

There is not a fixed number of skilled practitioners or good hospitals; the richer the society is, the more of both it can support. If everyone else’s real income doubles and mine increases only fifty percent, that means that the total supply of goods and services has gone up--roughly doubled. There is no particular reason why that shouldn't include the supply of medical services, permitting everyone else to consume twice the medical services he consumed before and me to consume fifty percent more than I consumed before.

Indeed, as things now stand in the United States, not everyone has access to even minimal basic care. (We are first among industrial nations in “preventable deaths” per capita—deaths that would not have occurred if the afflicted person had received competent and prompt medical attention for the ailment that later caused his death.) When there’s not enough for everyone, can there be any doubt that society’s lowest-ranked members are least likely to get the best care?

I am shocked to see an economist talking about “enough for everyone.” What do those words mean? Additional medical services would produce some benefit well past the point at which the entire GNP is spent on them.

As you have just conceded, what matters is not whether I get the best care but how good the care is that I get. When my absolute real income increases but my relative income decreases, I can afford better care than before, even if other people can afford care better still. So, in the case of medical care, it is absolute not relative that matters.

The importance of social rank for education is even clearer. We care about the absolute quality of education, to be sure. Even so, a “good” school in every society is an inescapably relative concept.

Schooling is a more complicated case because schools produce both education and status. So far as the education is concerned, a good school is not an “inescapably relative” concept, it is an absolute concept. If all schools get better, that means that students are learning more—becoming better doctors, lawyers, businessmen, parents, farmers, consumers of art and literature, or whatever they are going to use the education for. The result is a more productive economy with more stuff for people to consume and consumers better able to take advantage of what is available to them.

Do you really want to argue that schooling was as good in England in the tenth century, or in Cambodia or Ethiopia today, as it is in a modern developed society? That’s what your “inescapably relative” would imply.

It’s one that compares favorably with other schools. Such schools are almost always located in neighborhoods with relatively expensive houses. This is hardly surprising, since most parents want to send their children to good schools, and it’s relative income that predicts which parents will be able to outbid others for houses in the better neighborhoods that surround those schools. In contrast, if all we knew was a family’s absolute income, we’d have no idea whether it would be able to send its children to good schools.

If everybody gets richer, the quality of schools can increase everywhere. You are again confusing absolute and relative. The richer people will still, on average, have better schools--but the “worse” schools can be producing education as good as, or better than, the best schools used to produce.

Your claim is correct only with regard to the status output, not the schooling output. If you go to Harvard and I to Cornell, that may result in your winning out over me in our courtship of the woman both of us wish to marry. It may result in people who happen to know our backgrounds treating you with more deference than they treat me.

I do not know if it has occurred to you, but one implication of your argument is that spending on schooling, insofar as it produces status, imposes a negative externality on others, so private individuals will tend to buy a more than optimal quantity of schooling for their children. It follows, on straightforward economic lines, that instead of subsidizing schooling, as we do on an enormous scale, we ought to tax it. If schooling is “inescapably relative,” we could cut every school’s expenditure in half and still produce the same amount of education, relatively speaking, while saving many billions of dollars. Perhaps that should be the subject of your next op-ed.

David also believes that a society in which people were concerned about relative position would oppose policies aimed at reducing poverty. …

He goes on to suggest that my argument implies that “the rich ought to be in favor of grinding down the poor…” These remarks betray a curiously dark conception of human nature.

It was your conception, not mine, whose implications I was pointing out. You are the one who argues that people worse off than I am make me happy (and, in the current version of your argument, materially better off) and people better off than I am make me unhappy (and materially worse off).

All available evidence suggests that positional concerns are extremely local in nature. As Bertrand Russell once put it, beggars don’t envy millionaires, they envy other beggars who are doing a little better.

You are restating, in a stronger form, a point I already made in the post you are responding to. The problem with the observation that status externalities are local is not that it isn't true but that it destroys the conclusion you were arguing for in your op-ed—your justification for government income redistribution. The middle class suburbanite doesn’t receive a positive status externality from the poor welfare recipient in the inner city or confer a negative status externality on him, for just the reason that you and Russell point out. So your status argument provides no justification for taxing the suburbanite to benefit the welfare recipient. Following through on the logic of your argument while taking account of the local nature of positional concerns, you ought to be arguing for transfers from the working poor to their welfare neighbors, from wealthy suburban physicians to their less wealthy suburban professor neighbors, but not from the middle class suburbanite to the (much poorer) urban poor.

The local nature of status comparisons also undercuts your argument in a more indirect way, because it implies that the proper way of accounting for them is through private markets on a local scale not through national politics. Insofar as the people I am comparing myself to are part of a voluntary association--for instance, my fellow workers in a firm--the market will reward those at the bottom for the positive status externalities they confer on those at the top and charge those at the top for the status externalities they receive from those at the bottom. That, after all, was the point of your analysis of the effect on wage differentials of concern with status.

The effect is not limited to employment. Suppose I am an entrepreneur building a housing development. Some of the houses will be bigger and more expensive than others. Buyers of the more expensive houses are buying not only a bigger house but, along with it, the opportunity to feel superior to their neighbors—and will be willing to pay for it. Buyers of the smaller houses, on the other hand, are suffering the cost of having to look up to the neighbors; in order to sell the smaller houses, the developer will have to compensate them for that cost in lower prices. Just as in your analysis of intrafirm wage differentials, where status externalities exist, the market automatically includes them in its calcalation of costs and benefits and hence in prices.

As in many other cases, the market does an imperfect job of capturing externalities—in this case because not all of the local interactions occur in the context of voluntary associations of the sort I describe. But it does provide a mechanism for measuring them and an incentive to compensate for them at the level at which, as you have just pointed out, they actually occur—locally. The political mechanism provides nothing comparable.

If we adopt a Darwinian perspective on the forces that shaped human motivation, this is as we would expect, because similarly-situated others are the rivals that really matter in the struggle for survival. The non-poor simply have no reason to view the poor as rivals. They don’t compete for the same jobs, the same mates, or houses in the same school districts.

The critical one of these, in my view, is mate competition—that is what explains the human concern for status. Available mates really are a fixed resource, and competition for them is central to reproductive success, which is what evolution “as if designs” us for.

Because the local comparisons that matter most for the non-poor would be largely unaffected by anti-poverty programs, it makes no sense to say that positional concerns provide a motive for opposing those programs.

And therefor it makes no sense to say that positional concerns provide a justification for income redistribution at the national level—the claim you were making in the op-ed to which I responded. I was pointing out the implications of your argument, not agreeing with it and them.

Nor are positional concerns the only ones that motivate people. With the exception of sociopaths, people typically experience displeasure from the knowledge that others are in distress. Such feelings predict support for anti-poverty programs. Or perhaps the simple fact that life is unpredictable leads many to favor a generous social safety net as a hedge against the possibility that they themselves might become poor some day. In short, the fact that many voters favor anti-poverty programs does not mean they don’t value favored positions in the social hierarchy.

If status comparison occurred at the national level, which is what the argument for national income redistribution that you were making required, that would tend to make rich people opposed to lifting the poor out of poverty. Other factors working in the other direction might, of course, outweigh that one. So the observed politics of income redistribution do not prove that the argument you were making was wrong—I was indulging in hyperbole—they are merely evidence that it is wrong.

Perhaps more important, my point implies that your argument, true or false, has perverse implications. The more people believe it, the more they will see benefits to other people as costs to them. That does not mean that your argument is wrong, but it might be a reason not to publish it as an op-ed in the New York Times.

… If societies could form and dissolve as readily as private work groups can, an implicit market for social rank would emerge like the one we see in the labor market. Someone who didn’t want to be a net contributor under a society’s progressive tax scheme could simply persuade more productive others to form a new society in which he would have low social rank and be a net recipient transfer payments.

This would be a convincing argument if status comparisons were not local--but, as we both agree, they are. Hence they occur at a level at which groupings can and do form and dissolve. The more important such comparisons are, the greater the incentive to put them within such groupings, as in my example of the housing development. We do not need redistribution at a national level, which is what you were arguing for, because status comparisons don’t occur at a national level.

High social rank, as noted, has substantial instrumental value, and low social rank entails substantial concrete costs, irrespective of whether people care about rank per se.

That is your claim, but you have not supported it. Go back to the case of medical services. It is absolute level, not relative level, that determines access—because the supply of medical services is not fixed, any more than the supply of other goods and services. If we all get richer, we can all have more medical services.

This part of your argument hinges on the confusion, early in your response, between “finite” and “fixed.” Similarly for schooling, insofar as it produces education—being better educated is a benefit for me that does not depend on how well educated you are. Either it makes me more productive, and so gives me more money with which to buy stuff, or it makes me better able to live my life, appreciate literature, make choices, which again does not depend on how well educated I am relative to you.

The one place where the claim that relative status has instrumental value has real force is in competition for mates. But that’s because mates are a fixed resource—a fact which a sufficiently sophisticated calculation of changes in real income would take account of. If my money income goes up by five percent, everyone else’s money income doubles, and market prices stay the same, my real income may have actually fallen—because one of the prices not included in the price index is the price of obtaining a mate, and that has been bid up the increased income of my competitors.

Beyond that, your argument depends—as was clear when you first made it many years ago—on individual taste for status. From the standpoint of economics, that is merely an observed fact about utility functions. From the standpoint of evolutionary biology, it’s an implication of competition for mates.

One final point. There are indeed some positive externalities to low incomes and negatives externalities to high income, due both to the fact that people care about status and the fact that in some circumstances, although many fewer than you argue, relative status affects absolute access to resources.

But there are also negative externalities from low incomes and positive externalities from high incomes. Consider again the case of medicine. The cost of drugs is in large part the fixed cost of developing them. The more rich people there are who can afford cutting edge drugs, the lower their per unit cost and the wider the range of drugs available. Similarly for cutting edge surgical procedures and any other good where a substantial part of what is being produced is information. There is no reason in economic theory, and you offer no reason, to think that the net externalities run in the direction your argument requires—that making one person richer on net lowers the welfare of others. For all we know it raises it—in which case the consistent application of your arguments would require you to support redistribution from poor to rich.

I know better than to expect this argument to change many libertarian minds. Those who react at all are more likely to follow David’s strategy of searching out flaws in my argument. If you find some, I’d be grateful to hear from you.

Done.

Monday, May 10, 2010

Robert Frank's Reply

Robert Frank emailed me his reply to my post, with the explanation that it was too long for the blog software to accept as a comment. I am posting it here with his permission, and will be posting my re-response later.
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My column that provoked David’s comment also provoked a lot of angry mail from other readers who identified themselves as libertarians. None of them, however, made David’s good-faith effort to respond to my argument on its own terms. So I’m pleased that such a respected and able member of the libertarian community has responded to it with care. I will attempt to address his criticisms in a similar manner.

Yet there remain several ways in which we seem to be talking past one another. Most important, we disagree about the very nature of concerns about relative position. In my piece, for example, I claimed that high social rank has substantial instrumental value, observing that the highest-ranking members of society “know they will be able to send their children to the best schools and have access to the best health care. Low-ranking members enjoy no such confidence.” David disagrees, saying that this passage demonstrates my failure “to distinguish between absolute and relative values”: "Getting good health care,” he writes, “is very important to me, but its value does not depend, so far as I can judge by introspection, on other people having worse health care."

As I’ll argue in a moment, the failure to grasp the relevant distinction is his, not mine. He is correct, though, that demands for health and safety are among the least positional of all demands. Suppose, for example, that you ask someone to choose between two hypothetical worlds: World A, in which he has a 5 in 10,000 probability of dying on the job each year while the corresponding probability for other workers is 10 in 10,000; or World B, in which his annual probability of dying is 2 in 10,000 and the corresponding probability for others is 1 in 10,000. Almost everyone picks World B, the absolutely safe but relatively unsafe one.

But that fact has absolutely no bearing on my claim that persons of high social rank have greater access to the best health care. Resources are finite. The most renowned practitioners cannot provide the most costly medical treatments to every seriously ill patient. Indeed, as things now stand in the United States, not everyone has access to even minimal basic care. (We are first among industrial nations in “preventable deaths” per capita—deaths that would not have occurred if the afflicted person had received competent and prompt medical attention for the ailment that later caused his death.) When there’s not enough for everyone, can there be any doubt that society’s lowest-ranked members are least likely to get the best care?

The importance of social rank for education is even clearer. We care about the absolute quality of education, to be sure. Even so, a “good” school in every society is an inescapably relative concept. It’s one that compares favorably with other schools. Such schools are almost always located in neighborhoods with relatively expensive houses. This is hardly surprising, since most parents want to send their children to good schools, and it’s relative income that predicts which parents will be able to outbid others for houses in the better neighborhoods that surround those schools. In contrast, if all we knew was a family’s absolute income, we’d have no idea whether it would be able to send its children to good schools.

David also believes that a society in which people were concerned about relative position would oppose policies aimed at reducing poverty. Thus, he writes,


"Back when Lyndon Johnson was pushing the War on Poverty, his claim was that it would eliminate poverty, result in poor people no longer being poor. If Frank is correct, that claim should have been a death sentence for the program. On his argument, after all, I benefit by other people being poor, since it raises my relative status, and so would be worse off if they stopped being poor. The great majority of voters, then and now, are not poor, so if he is right the great majority should have viewed what Johnson claimed to be doing as hurting them, and voted against it. That isn't what happened. For Barack Obama to center his proposals for health care on making it available to the small minority of uninsured individuals should have been political suicide if Frank is right. But the bill passed."

He goes on to suggest that my argument implies that “the rich ought to be in favor of grinding down the poor…” These remarks betray a curiously dark conception of human nature. Being concerned about relative position surely does not imply taking pleasure in the knowledge that others are poor. If it did, middle-income people would spend long hours observing people in poor neighborhoods, thereby to boost their own self-esteem. That they don’t choose to spend their time this way doesn’t mean they don’t care about relative position.

All available evidence suggests that positional concerns are extremely local in nature. As Bertrand Russell once put it, beggars don’t envy millionaires, they envy other beggars who are doing a little better. If we adopt a Darwinian perspective on the forces that shaped human motivation, this is as we would expect, because similarly-situated others are the rivals that really matter in the struggle for survival. The non-poor simply have no reason to view the poor as rivals. They don’t compete for the same jobs, the same mates, or houses in the same school districts. Because the local comparisons that matter most for the non-poor would be largely unaffected by anti-poverty programs, it makes no sense to say that positional concerns provide a motive for opposing those programs.

Nor are positional concerns the only ones that motivate people. With the exception of sociopaths, people typically experience displeasure from the knowledge that others are in distress. Such feelings predict support for anti-poverty programs. Or perhaps the simple fact that life is unpredictable leads many to favor a generous social safety net as a hedge against the possibility that they themselves might become poor some day. In short, the fact that many voters favor anti-poverty programs does not mean they don’t value favored positions in the social hierarchy.

Rank is a reciprocal phenomenon. High-ranked positions cannot exist in the absence of low-ranked positions. In virtually every private work group, the pay schemes we observe embody an implicit progressive tax that transfers substantial income from the most productive workers to the least productive. On my argument, work groups with mixed productivity levels would quickly dissolve except for this transfer, which creates an implicit market for local rank.

Those who particularly value high local rank can purchase it by transferring some of their pay to their less productive co-workers, without whose presence they would not be able to enjoy high rank. Everyone wins under this arrangement. The least productive workers get a pay premium larger than necessary to compensate them for the burdens of low rank; and the most productive workers take a wage cut that is smaller than the value they assign to high rank.

This arrangement provokes no complaint from libertarians because it is completely voluntary. Someone who doesn’t wish to purchase high local rank doesn’t have to. Instead, he can join a group in which he would be one of the least productive members and be paid more than the value of what he produces.

There would be no similar escape hatch for society’s most productive workers under a society-wide redistributive tax scheme. Even those who insisted they did not value high social rank would face mandatory tax payments to finance transfers to their lower-ranked fellow citizens. From the libertarian perspective, that’s an objectionable feature of redistributive taxation, to be sure.

But is there an alternative that would be as good or better? If societies could form and dissolve as readily as private work groups can, an implicit market for social rank would emerge like the one we see in the labor market. Someone who didn’t want to be a net contributor under a society’s progressive tax scheme could simply persuade more productive others to form a new society in which he would have low social rank and be a net recipient transfer payments.

But transaction costs rule out that option. For the most part, we’re stuck in the societies we’re born into. The upshot is that social institutions cannot be fine-tuned to suit every individual preference. We must choose rules that work as well as possible for people with highly divergent talents and interests.

High social rank, as noted, has substantial instrumental value, and low social rank entails substantial concrete costs, irrespective of whether people care about rank per se. Forcing a productive person to buy more social rank than he wants is objectionable, but the alternative is to give all of society’s most productive members a valuable asset free of charge. That asset would command a high price in the libertarian’s ideal world in which purely voluntary societies could form and dissolve at will. And since its value is a direct consequence of the substantial costs associated with low social rank, a society without redistributive taxation should strike libertarians as even more objectionable.

Ronald Coase argued that when transaction costs make private negotiation an impractical way to limit damage from externalities, collective action should try to mimic as closely as possible the solutions people would have adopted if transaction costs had been zero. When the externalities in question are distributional in nature, the clearest indications we have about what those solutions would look like are the pay schemes we observe in private firms. In virtually every instance, those schemes embody a steeply progressive implicit tax. In my view, those observations make redistributive taxation defensible, even within the libertarian framework.

Almost without exception, however, my libertarian friends belief that redistributive taxation is morally indefensible. This belief implies that society’s most productive members should be entitled to their valuable positions free of charge just because transaction costs make it impractical to negotiate private solutions to distributional externalities at the society level. That claim, I believe, is squarely at odds with libertarian principles.

I know better than to expect this argument to change many libertarian minds. Those who react at all are more likely to follow David’s strategy of searching out flaws in my argument. If you find some, I’d be grateful to hear from you.

Wednesday, May 05, 2010

Robert Frank, Status, and Income Redistribution

Economists usually assume that what individuals care about is their absolute level of income, that if my income goes up by ten percent and everybody else's by twenty that is still a plus, not a minus, for me. Many years ago, in Choosing the Right Pond, Robert Frank pointed out that that is not an accurate description of real human behavior. People care about their absolute level of income (and other things), but they also care about their relative status, which depends in part on how their income compares to that of others. The point itself is fairly obvious; what was interesting about Frank's work was that he went on to show how a taste for relative income could be incorporated into an otherwise conventional economic analysis.

Consider a firm that employs a variety of workers of varying productivity. A standard competitive model would predict that salaries would scale in proportion; if one worker produces twice as much as another, he will be worth twice as much to an employer and will end up being paid twice as much.

Suppose, however, that workers care about both absolute and relative income, the latter being defined relative to fellow workers in the firm. The low productivity worker now contributes an additional input, immaterial but real, to the firm—his presence raises the relative status of the more productive workers, making them happier. The high productivity worker contributes a similar, but negative, input, since his presence lowers the status of other workers, making them less happy. Changes that make workers more or less happy ultimately show up in the firm's bottom line, since it costs less to hire workers the more they like the job. Hence, under Frank's assumptions, the low productivity worker will be paid more than in proportion to his physical output, the high productivity worker less. The market outcome thus incorporates something that looks rather like income redistribution.

In a recent New York Times Op-Ed, Robert Frank offered this analysis as a justification for explicit income redistribution by government, writing:

"Enlightened libertarians believe that the best social institutions mimic the agreements people would have negotiated among themselves, if free exchange had been practical. Private pay patterns suggest that our current tax code meets that test."

It is an ingenious argument, but there are at least three problems with it:

1. Frank's analysis of the effect on pay of concern with status implies that what people care about is not their status relative to the rest of the world but their status relative to those near them—in his case, their fellow employees. The more distant someone is from me, the weaker the effect—a fact some of whose implications I discussed long ago on this blog. Most of the people who benefit from income redistribution are very far from me. That does not eliminate his argument, but it weakens it. When he writes

"For starters, high-ranking members of society, who also tend to have the highest incomes, know they will be able to send their children to the best schools and have access to the best health care."

he fails to distinguish between absolute and relative values. Getting good health care is very important to me, but its value does not depend, so far as I can judge by introspection, on other people having worse health care.

2. Back when Lyndon Johnson was pushing the War on Poverty, his claim was that it would eliminate poverty, result in poor people no longer being poor. If Frank is correct, that claim should have been a death sentence for the program. On his argument, after all, I benefit by other people being poor, since it raises my relative status, and so would be worse off if they stopped being poor. The great majority of voters, then and now, are not poor, so if he is right the great majority should have viewed what Johnson claimed to be doing as hurting them, and voted against it. That isn't what happened. For Barack Obama to center his proposals for health care on making it available to the small minority of uninsured individuals should have been political suicide if Frank is right. But the bill passed.

3. The most serious problem with Frank's argument, suggested by the previous point, is that if it is correct he ought not to be making it, since its implications are ones of which he clearly disapproves. He puts it in terms of what "enlightened libertarians" think social institutions should be. But as an economist, he surely believes that people's behavior mostly reflects their perception of their own interest. The implication of his op-ed is that it is in the interest of everyone to make everyone else poorer, thus raising his relative status. The rich ought to be in favor of grinding down the poor, the poor ought to be in favor of pulling down the rich, and the people in the middle ought to be in favor of both. I do not think that describes the policies that Robert Frank, who is a nice man as well as an able and original economist, wants.

Do Greek Protesters Want a Default? Should They?

Lots of people in Greece have been demonstrating, sometimes violently, against the government's "austerity" program, adopted as the price of getting loans to cover Greece's very large national debt. It is not clear from the stories I have seen what alternative they propose.

One possibility is that they believe the Greek government could continue its current policies if it wanted to, that the austerity program is merely a plot by wicked people to make the protesters, and people like them, worse off. It is hard to see how a government can continue to spend much more than it takes in if nobody is willing to lend it money, but that may not be how they are looking at the question.

An alternative possibility is that they realize that rejection of the program will result in their government being unable to either borrow more money or turn over its present debts, leading to a sovereign default, and are in favor of it. That raises two questions. The first is whether that is what the protesters, or many of them, want. Readers who have followed the situation more closely than I have are invited to offer any relevant evidence.

The second is whether, in terms of their own self-interest, it is what they ought to want. At first glance, one would think not. The program being proposed is not austere enough to put the Greek budget into surplus; under it the government would still be spending more money than it takes in, although not as much more. If defaulting on its present debt makes the Greek government unable to borrow, that would force a balanced budget and presumably lower, not higher, expenditures than currently proposed—the opposite of what the protesters want.

But the answer is not that clear. For one thing, current budget calculations include interest payment on the current debt; defaulting on that debt would eliminate those payments. I don not know the details of the proposed budget, but it is at least possible that a balanced budget with current income and without interest payments would result in an increase in (non-interest) expenditure.

Furthermore, default will not make borrowing impossible. My friend Jeff Hummel quotes me as saying—when and where I don't know—that sovereign default is the one balanced budget amendment with teeth. I do not know if I really said it, but if so I was exaggerating. Defaulting once is bad for one's credit rating, but defaulting twice is worse, so after a sovereign default a government still has some incentive not to do it again, hence some reason to pay off on any further borrowing. And the first default reduces the incentive for the second, since there is no wless debt to default on—the benefit of eliminating a billion dollar debt is much less than the benefit of eliminating a hundred billion dollar debt. So after default, a government should still have some ability to borrow.

Which raises the question of whether a Greek government that had defaulted would be willing and able to spend more money, some of it taxed and some of it borrowed, than currently proposed. If so, perhaps the protesters are correct in believing that rejecting of proposed program would lead to a better result, from their standpoint, than accepting it.

This is not only a post about Greece. The argument in favor of sovereign default applies to a lot of other governments as well, including the U.S. I find the rarity of such defaults—and the willingness of people to lend large amounts of money to borrowers who face no legal penalties if they fail to pay it back—at least mildly puzzling. Presumably the explanation lies in indirect costs to default, reputational and otherwise.

One further point is worth making, emphasized by the Greek situation—the existence of positive feedback. The greater the perceived risk of default, the higher the risk premium that lenders will require on their loans. The higher the risk premium, the more costly the debt, hence the greater the incentive to default. So if a sovereign default does happen, it could be surprisingly sudden.