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I teach masters students the basics of micro- and macro-economics. When we talk about government intervention, one of the first topics is the effect of taxes in an otherwise competitive market. By this point, it’s pretty easy for them to see that taxes hurt both consumers and producers in that market because, generally, (1) buyers have to pay more for the good than before and sellers receive less in revenue than before and (2) taxes reduce the activity that is being taxed, lowering surplus for everyone. For example, if it costs a seller $1 to make a cup of coffee and every day she was selling one to a buyer who was willing to pay only $1.05 (presumably for some amount between $1 and $1.05), placing a 10-cent tax on that market will probably eliminate that transaction. This second effect is called the “deadweight loss” of taxation because losing these transactions creates only costs (to the affected buyers and sellers) and no benefits (because the government doesn’t get tax revenue and consumers/producers do not benefit from transactions that don’t happen). That doesn’t mean we should never have taxes in competitive markets: if the government puts the tax revenue to good use, then social gains can overcome the deadweight loss. It just means there’s no free lunch!
It’s important to note that the assumption here is that we don’t want to limit the economic activity itself (e.g., because it generates pollution). When we talk about “externalities” such as pollution and how taxes can be used to resolve them, I usually ask “Do taxes to correct an environmental externality create deadweight loss?” By this point, a lot of my students have learned to equate taxes with “deadweight loss”, so many will generally say “yes”. However, that is not the case (but I’ll save that for another post).
After we cover taxes, I ask my students: “Do subsidies (in the form of a payment per unit of something produced/sold) in otherwise competitive markets create deadweight loss?” I always think this is an easy question because a subsidy is just a negative tax. The answer then should clearly be “yes”, but the students are usually stumped. So I thought I would write a post about the economics of subsidies.
Unsurprisingly, subsidies work in the opposite way that taxes do: they generally benefit both buyers and sellers by raining the amount a seller receives for selling a good and lowering the amount a buyer pays. No one participating in a subsidized market has an incentive to want to get rid of the subsidy because both sides benefit! Subsidies also increase the amount of the subsidized activity – add a 10-cent-per-cup subsidy for coffee and people will drink more coffee. Someone who wasn’t willing to pay more than $0.95 for that cup of coffee may now buy it for $1 because they also get a ten-cent subsidy that offsets some of that cost. Alternatively, if the subsidy goes to the seller, the seller may lower the price to $0.93, also inducing the buyer to buy.
But this increase in economic activity is not a good thing because the additional “units” being produced and exchanged are costing more to make than the buyers value them at. The net benefit (value to consumer minus cost to producer) to society of this additional economic activity is negative because the buyer values the good less than what it costs to produce. On top of that, subsidies need to be paid for by taxes, which means possibly creating deadweight loss in another market!
One justification people give for supporting subsidies is distributional concerns. Maybe we’re losing some efficiency, but we’re making sure that (presumably poor) people can afford to buy the good in question. However, subsidies are a crude and expensive way for achieving distributional goals because they help everyone who buys in the market, rich or poor. For example, subsidizing college education will certainly help poor students, but if the subsidy is given to everyone, it becomes much more expensive in terms of the amount of revenue (and deadweight loss of taxation) that needs to be generated.
An obvious way to improve on subsidizing something for everyone is more targeted subsidies (like financial aid for poor students). However, even that is not ideal because it distorts individuals’ choices. If we start subsidizing coffee for low-income individuals, coffee will be more affordable, but people will also drink more of it relative to other goods, and it’s not clear that we (or the individuals) want that. Rather, economists advocate giving poor individuals money and letting them decide what to spend it on. That comes with its own set of issues because it creates a larger incentive to pretend to be low-income, but it also respects individuals’ choices and does not lead to unnecessary distortions.
My representative, Rodney Davis, recently introduced a health care bill "to protect people with pre-existing conditions from discrimination against insurance companies." (yes, if you think about it, that sentence is poorly written).
I just wrote to him to ask a few details about his plan. I'm sharing the letter below because it demonstrates the difficulty of ensuring that individuals with pre-existing conditions can buy affordable insurance.
"I read about your new health care bill to make sure people with pre-existing conditions can buy health insurance. I'm just curious as to what happens if insurers offer someone who has cancer insurance for, say, $50,000 per year. Would you consider that acceptable? If not, what provisions does your plan have in place to ensure that does not happen?
If your plan has limits on whether insurers can charge different prices based on pre-existing conditions, how will the plan ensure that younger and healthier people do not have a disincentive to sign up because they are being offered insurance at a price that is much higher than their expected healthcare costs?"
There are really only two ways (that I can think of) to ensure that (1) people with pre-existing conditions are not being offered health insurance only at exorbitant prices and (2) you don't create a "death spiral" where people buying insurance on the individual market are increasingly sick because the healthier people drop out due to rising prices. The first is having an individual mandate (a stick) and the second is a generous tax credit that makes buying health insurance very cheap on the margin even if the pre-credit price is very high (a carrot). I look forward to seeing what Davis's actual plan is (the "Better Way" Republican agenda does mention a tax credit).
(This is based on a true story, but I may have changed some details like field of study and gender to protect the student’s anonymity)
Shortly after Trump got elected president, a student made an appointment to talk to me. She was in the last year of her finance degree and had a good job lined up, but was doubting whether she should continue with her life plan in light of the election. She realized that she wanted to make a difference in the world and a career path in finance didn’t seem like a good way to do so. Instead, she was considering going to work for a women’s reproductive rights organization (I definitely changed this detail, but it roughly captures the spirit of this student’s desires).
I told her to consider sticking to finance and donating a large part of her salary to her favorite organization. Why? Because individuals who hold high-paying jobs can often make a lot more of a difference this way. Her starting finance salary would have been probably at least $120,000 a year. If she left finance and went to work for the non-profit, she would make at best $40,000 a year. But what if she donated $80,000 of her finance salary to the non-profit instead? Well, the non-profit could hire TWO people like her and she would still earn $40,000 per year, as much as she would have at the non-profit.
Of course, there are some caveats to this. She would probably have to work longer hours in finance and maybe she would enjoy it less than the non-profit job. So to stay indifferent between the two, maybe she would donate “only” $50,000. Still, the organization might prefer having that money to having her work there, especially if she didn’t have any special training.
That brings me to the second piece of advice I gave her. If, after considering the high-paying-job-plus-donations option, she still thought going into the non-profit world was better, I advised her to think about positions in non-profits where her finance training would be useful. For example, if she wanted to help low-income women, perhaps she could get involved with an organization that provides financial training to disadvantaged women or manage a non-profit’s endowment. Even though that may not have been her first choice, it would probably be more valuable to society.
So as we sit here wondering, “What the f*** do I do now?”, consider whether your salary allows you to make a substantial donation to the many organizations out there fighting the good fight. If you’re a student, don’t feel like you have to drop everything and become a full-time activist (though you should still call your Congressman once in a while and follow the non-alternative news!). First, sit down and think about how much money you can generate for your favorite organization by not working for them. Alternatively, consider which causes your skills could be useful for – a lawyer going to work for ACLU is a lot more useful than a lawyer going to build houses for Habitat for Humanity.
To be clear, I am not saying that you should take a job you find immoral or incredibly unpleasant. There is ultimately nothing wrong with leaving (or not taking) a high-paying job where you don’t feel like you’re making a difference for a low-paying job where you feel like you do. And of course we need people actually working at organizations like ACLU or Planned Parenthood (yes, I’m shamelessly promoting my favorite ones). But these organizations need money too, and if you face a high opportunity cost of joining them full-time (i.e., your salary is or will be high), consider giving them your money instead. You might not get the same pat on the back from your activist friends, but I promise you that you will be making a big difference!
Most people are taught in introductory economics courses that they should ignore "sunk costs" (costs that cannot be recovered) in their introductory economics courses. But sometimes decisions involving sunk costs can be tricky, as a recent example I came across illustrates.
I have a "friend" who booked a spring break trip to the Dominican Republic with her two kids and husband nine months in advance. About two weeks before they were scheduled to leave, she realized they didn't have a passport for their younger son. They didn't forget, they didn't procrastinate, they didn't think he DIDN'T need a passport (their older daughter had one) - they just didn't think about it. It's one of those inexplicable things like a woman who doesn't realize she's pregnant until she goes into labor. On top of that, American changed their flight itinerary in a way that would make them have to spend a night in Chicago on the way there and probably on the way back. So they were not happy.
As it turned out, it was possible to get a passport on such short notice, but it would involve driving to Chicago (which is 2.5 hours away) during a work day with the son. But the question is, should they do that? Or should they cancel their vacation and stay home? Unsurprisingly, the answer depends on whether or not the airfare and hotel are refundable.
If the trip is not refundable (= sunk cost), it should make my friend MORE likely to go on this vacation than if it's refundable. Why? Because then the (marginal) cost of the nice vacation becomes the time and effort to drive to Chicago, the two nights' hotel stay in Chicago, and the unpleasantness of dealing with all that. That's not too bad for a fancy week-long vacation in the Dominican Republic. On the other hand, if the trip is fully refundable, then you have the costs already listed PLUS the money paid for the trip (because you could get the money back, it's as though it's still sitting in your bank account and you're considering whether to buy the trip). And while my friend was willing to buy the trip when the flights were easier and the document issue was not on her mind, adding these things into the mix tipped the balance against the trip.
As it turns out, the trip was almost fully refundable, so the family decided to cancel the trip. The moral of the story is that whether or not a cost is sunk changes the marginal cost of doing something and you should consider that next time you forget that you need a passport to go to Canada and find yourself without one.
And I'll be staying in Champaign over spring break...
Vaccines prevent diseases and that's awesome because even relatively mild diseases like measles and chickenpox kill or disable a minor share of the people they infect. So it is without a doubt that vaccines have prevented billions of sick days and saved many many lives (don't even go there, anti-vaxxers).
But there's another important benefit of vaccines that I've never seen highlighted - the time they save the parents by reducing the amount of time they have to spend taking care of sick children (I had this epiphany last week when both of my children were sequentially sick and home from daycare). And if your child is constantly home sick, even with routine childhood diseases, it makes it difficult to hold down a job. Undoubtedly, in the pre-vaccines era, this burden would have fallen largely on women. Of course, children still get sick, but my guess is that vaccines made it significantly easier for women with children to hold steady jobs. So the research question is, "What is the effect of vaccines on female labor supply?" Potential title of paper: "Vaccines and Female Labor Supply". You're welcome.
Answer: when you find yourself citing a paper that cites your working paper.
(or maybe I'm just slow)
Taylor Swift has been enjoying her market power in the music world lately, pulling her music from Spotify last November and, most recently, standing up to Apple over its proposal to pay no royalties for songs that Apple Music users listen to during a free three-month trial period. In response to Taylor’s public denouncement of Apple (coupled with her pulling her new album from the service), Apple backed down, promising to pay royalties during the free period as well. So did Taylor Swift score one for the music industry? I say “yes” and “no”. Here are the two ways of looking at this (I’ll start with the counterintuitive “no”).
“No”: What ultimately matters is the total amount of compensation the average artist receives. While it may be tempting to conclude that all artists will now earn more from their music, that isn’t necessarily the case. Apple has not finalized its terms with the artists and the effect of this policy change may be to lower the overall royalty rate. If this happens, artists whose music gets played a lot by people who sign up and then leave when the free trial is over will win; artists whose music is played a lot by paying customers may very well end up with lower payments than they would have received under the original agreement. Will this kind of offsetting effect actually happen? That depends on how much market power Taylor Swift v. Apple have. Which brings me to my next point.
“Yes”: Taylor Swift is incredibly popular, giving her a lot of market power. If negotiations with Apple were artist-specific, she could certainly negotiate a great compensation package for her songs. But it seems pretty clear from what I've read about the negotiations that there are at least some terms that apply to everyone. To the extent that (a) there are common terms for all artists and (b) Taylor can affect those terms, her actions did indeed raise all artists’ profits. And, of course, there is the question of public relations. Ultimately, both Apple and the music artists are counting on subscribers for revenue; if the negative PR generated by not paying artists during trial periods costs Apple a lot of paid subscribers, it may be better to pay more, period.
The overall point of this post is similar to that of the previous one: it’s important to pay attention to the total compensation package, not just individual parts.
Yesterday, the California Labor Commission decided that Uber's drivers were employees, not independent contractors. Articles all over the web, including this one from Business Insider, claimed that this could "dramatically change Uber's business model". For example, if drivers are contractors, Uber doesn't have to withhold income taxes or pay for drivers' expenses. So this ruling seems like it could be a big deal, right?
Some of the differences between a contractor and an employee are superficial, and while they may affect administrative practices, they may only have a trivial effect on Uber's bottom line. Why? Because compensation for a job is multi-faceted, and making compensation more generous in one way will enable a company to make it less generous in another way. Going back to the examples above, making Uber withhold income taxes should have little to no effect on its expenses because independent contractors have to pay income taxes as well. Similarly, drivers will demand more compensation for a job where they have to pay for their own car maintenance and insurance than for one where those expenses are paid for them. So the parts of the ruling that simply shift costs from drivers to Uber shouldn't make a big difference.
Now some of the differences between employees and contractors are more meaningful. For example, it's much easier to fire a contractor than an employee, and, according to Business Insider, employees may be entitled to an hourly wage, whereas independent contractors are not. In this case, the shift is not just in who pays for things, but in how variable employees' earnings versus Uber's revenue is. If Uber pays drivers a regular hourly wage and takes in any revenue the drivers bring in, then Uber is taking on more risk than the employee. Employees might prefer that system because it lowers their earnings variability and even be willing to work for a lower wage on average. In this case, Uber's revenue can actually increase (and, at the same time, become more variable). However, this loss of flexibility might actually harm Uber if it generates higher swings in its revenue than it can weather.
Last week, I received the following email about an awesome new organization:
I think this is a great initiative to (a) give researchers a better idea of how long journals take and (b) put pressure on journals to be faster with their reviews by creating transparency. Consider joining and tracking your own review experience!
Economists have studied price discrimination (charging people different prices for the same good) for decades. In general, we divide price discrimination into three types. One is “first-degree price discrimination”, where you know someone’s exact willingness to pay for a product and charge them that price. This type of price discrimination is not particularly interesting because in a world with many different individuals, it’s practically impossible to know a person’s willingness to pay exactly. You can come close, however, if you observe a person’s characteristics (e.g., age, gender, income) and you know how willingness to pay varies with such characteristics, on average. This is known as “third-degree price discrimination”, and it manifests itself in student and elderly discounts, ladies’ nights, and so on.
The most interesting type of price discrimination is “second-degree price discrimination”, where consumers self-select into different pricing schemes. A great example of this is coupons. Generally, the more money you make, the more you are willing to pay more for most goods. Thus, stores would love to charge higher-income people more for the same good. Of course, it’s very hard for a store to know how much money people make (and no one will tell you they make a lot of money if they know this means paying a higher price!). Coupons are a great way to get high- and low-income consumers to pay different prices. High-income individuals are generally less willing to spend their time clipping coupons. Thus, a store can get them to pay more for the same good by posting a high price and issuing a coupon that people have to go out of their way to get (mail-in rebates represent a similar idea).
Not to be behind traditional retailers, Amazon has also introduced coupons. In its “Prime Pantry” area (where Prime members can buy individual grocery items and pay $5.99/box flat shipping), many products have coupons associated with them (as of this writing, this and this were good examples). The funny thing is that the “coupon” is a button on the product page. All you have to do to get the discount is press the “Clip Coupon and Save” button before adding the product to your cart. Why doesn’t Amazon simply lower the price of the item and get rid of the coupon? Are people with higher willingness to pay really so lazy or inattentive that they will not notice and/or press a coupon button that’s right there in front of them? I find that hard to believe.
As in my previous post, I don’t have a definitive answer, but I have two guesses (if you work for Amazon and can tell me how often people who see the coupon don’t click on it, please do!):
It’s also possible that Amazon hasn’t thought this coupon thing through carefully, in which case you’re welcome, Amazon.