Analysis

Principle

Break problems down into smaller parts to gain a better understanding.

The way to break the problem down may be obvious, or even contained in the question. But sometimes it is useful to break the problem down in non-obvious ways.

Tip

A fairly obvious way of breaking down a problem into parts is to look step by step at how some cause has some effect. Example: what impact does reducing taxes on labor income has on wages? Look first at the impact of the tax reduction on how much workers want to work, and then look at the impact of the latter change on wages.

When determining how to break down the problem in non-obvious ways, you may often want to define parts that are independent of each other. (See the example below).

Example

What impact does a reduction of tax rates on labor income have on how much workers want to work?

You already know (maybe using the art of caricature) that a reduction of tax rates has two effects. There is an “income effect”: even if the worker works the same, she will be richer because she will keep more of her labor income. This may be an incentive to work less (but you are not sure at this stage). The second effect is that, in addition to the previous effect, the worker has an incentive to work more because she will keep a larger proportion of her additional labor income. This is called the “substitution effect”: it is an incentive to substitute something by some other thing (here leisure by work) because the relative price of these two things has changed, but which comes in addition to the income effect mentioned above.

It would be useful to separate the substitution effect from the income effect. In order to do it, break the tax-rate reduction into the two following parts. Consider first a fiscal reform that would consist of our tax-rate reduction and of a lump-sum tax calibrated such that the worker pays exactly the same tax as before if she does not change her work load. This may seem quite artificial, but it is constructed in order to get a pure substitution effect (since the income stays the same if the work load stays the same). Second, consider a fiscal reform consisting of giving back the lump-sum tax discussed above. In this second reform there is no change of the tax rate: the change of income does not depend on the work load. Thus, this leads to a pure income effect. And the sum of the two reforms is our tax-rate reduction.

Think about the first reform. It is clear that this reform is an incentive to work more, since the worker will keep more of additional labor income and there is no issue about increased revenue with the same work load that would make this picture fuzzy.

Let’s now forget about the first reform and think about the second reform. Since the sole change for the worker is that it makes her richer (but without changing her after-tax wage), it seems obvious that she will want to work less. But you surely can imagine a case in which she would want to work more. Maybe thanks to the money provided by the state she can take out a mortgage to buy the house of her dreams if she works a bit more, whereas she would not have enough incentives to work that bit more before that reform because it was not worth her while to work more to buy more small things (your common sense will probably tell you that this is rather exceptional, but to really understand why we will need the trick in the next post).

Exercise

What is the impact of rent controls?

The art of caricature

Principle

To get insights about the real world, consider extreme (even unrealistic) cases.

Stage 1: Consider extreme cases. Don’t care about realism at this stage.

Stage 2: Would some of the features of your extreme cases subsist in less extreme cases? Does that give you an insight about the real world? If yes, that’s nice. If not, that was a nice try.

This trick might give you some idea about what may actually exist. More work is usually needed to prove that it can in principle actually exist, and even more work is necessary to prove empirically that it actually exists. This trick never shows that something cannot exist (if your extreme cases do not have some property, that doesn’t prove that this property will necessarily be absent in all other cases).

Tip

If a parameter is crucial for the question you have to answer, it might be useful to try extreme values of this parameter, even when they are unrealistic.

Example

What impact does a reduction of tax rates on labor income have on how much workers want to work?

Stage 1:  What happens if the tax rate is originally equal to 100% (this means that workers have to give up their whole labor income to the state)? Obviously workers won’t work (assuming away the interest for the job, other kinds of reputational compensation, or any social pressure). Then, assume that the tax rate is reduced, let’s say to 20%. Will workers work? It depends on how rich they are. Let’s say they receive some money from the state (do not consider where the money comes from; maybe the state has a sovereign fund financed in the past by selling a huge amount of diamonds). If what they receive barely suffices to survive, they will be likely to work when the tax rate is reduced to 20%. If each worker receives billions of dollars each year, and their labor incomes would be tiny in comparison, it is likely that they will not work. Thus while lowering the tax rate will tend to encourage workers to work more, having a higher income will reduce their motivation to work more.

Stage 2:  The insight is that reducing tax rates may, but will not necessarily, motivate workers to work more. Income has to be taken into account. What would happen if we started with a tax rate under 100% (for example 30%)? In the real world, we can forget about workers receiving huge amounts of money from the state. They will already be working before the tax reduction, and thus paying taxes. This means that the tax reform would make them richer even if they do not change their work load, because they would keep more of their labor income. Thus, two variables are changing simultaneously: the tax rate and the income of workers. And it may well be the case that these two variables have opposite incentives on work (as in our extreme case). We cannot yet be sure that these variables will generate the same incentives in the general case as in our extreme case, but this might be a possibility.

By the way, a tax rate of 100% is not as unrealistic as it sounds. This would happen if the state guaranties some minimal revenue by transferring the difference to workers who earn less than that. In this case, if the worker earns 100 dollars more but stays under the threshold, she will still have the same total income (labor income + transfers). This means that, for her, the tax rate is 100%. Thus, she has no incentives to work more (as long as she stays under the threshold). That’s called the “poverty trap”. Thus a tax rate of 100% is not necessarily unrealistic, but considering that extreme case would have been useful even if it were completely unrealistic.

Exercise

What may be the impact of rent controls?

What else will also change?

Principle

When assessing a policy change, also take indirect impacts into account.

Tip

A good way to identify indirect impacts is to consider all agents and ask yourself how the policy change may affect their decisions. Then examine how these changes in their decisions may have further impacts, and so on.

Example

The tax rates on labor income are reduced. What kind of impacts may this policy change have?

A direct impact is that, thanks to that reform, workers will have more money after paying their taxes. Being richer may have an impact on how much workers want to work. Moreover, the fact that they will keep more of the money they will earn from working more may also have a direct impact on how much they want to work. How much workers want to work may have an impact on wages, etc.

To discuss all these links in more detail, you need to have some idea about i) how workers decide how much they work (insofar as they can choose), ii) how wages are set, etc.

Exercise

A regulation is introduced to prohibit rents from being higher than some limit (price controls). What kind of impacts may this policy change have?

Models versus words

(This is my comment on « How to answer “true, false, uncertain” questions » by Frances Woolley).

Your post is interesting. I have no doubt that it will be useful for students. It made me think about certain weaknesses of current practices in teaching economics.

You first speak about the “true by definition” type of questions. I hope there are not too many of them, because definitions by themselves have only the appearance of knowledge.

It is often said that we have to find in our tool-box the relevant model. You give precise tips about how to find the right model. That would be a good step for programming artificial intelligence for answering such questions. But a student who has to rely on such clues surely lacks familiarity with the models.

Then you answer the question « True, false, uncertain: "Natural gas price controls during the late 1970s hurt producers at the expense of consumers, but did improve economic efficiency." ». Your answer is standard, but I don’t like it. I don’t like the use of diagrams (and of economic jargon). I think that it obscures rather than illuminates the question. In one sense, it is an overkill since a verbal answer would have been sufficient. But in another sense it is less than a verbal answer since it is too specific. Implicit assumptions and loose ends are quite hidden in the diagram presentation, whereas a verbal answer can more easily be connected to common sense and public debate, and thus its weaknesses can more easily be spotted. What is the likelihood that a student will notice that perfect competition is assumed, and ask to either prove that this assumption was satisfied in the natural gas market in the late 70’s or prove that your point is still valid when competition is imperfect? What student will notice that the price in the diagram does not include some externalities (like pollution)? Another weakness of diagrams is that drawing them necessitates assuming some slopes, even if the conclusion does not depend on those slopes. We surely can hope that students will understand that your conclusion about the efficiency loss triangle is still valid with other slopes (of the same sign) and that other points (like whether the consumer surplus is larger or not thanks to price control) depend on the slopes. But if the conclusion does not depend on the slopes, it seems it would be more efficient that they do not enter the discussion. They are necessarily part of a diagram, but a verbal discussion tends more naturally to either avoid them or be explicit about the various possible cases.

It is said that a picture is worth a thousand words. But it seems to me that verbal answers (I give mine on my blog) have certain advantages. I would even go so far as to argue that models (even a simple diagram) should be taught only when they are really necessary for answering a relevant question (just using a model for the sake of using it is not relevant).

Natural gas price controls

« True, false, uncertain: "Natural gas price controls during the late 1970s hurt producers at the expense of consumers, but did improve economic efficiency." ». Here is my answer to that question (this question is discussed in an interesting post « How to answer “true, false, uncertain” questions » by Frances Woolley).

Price controls drive the price lower than it would be without it. Everything else remaining the same, it is a transfer from the producers to the consumers. But everything else does not remain the same.

Producers

Since the price is lower, producers will try to reduce their costs. A typical way to reduce costs is to reduce production since it typically costs more to produce the last unit than a preceding unit. Firms whose costs are too high may also go out of business, thus reducing global production. Insofar as this applies to natural gas production in the late 70’s (natural gas is a quite special product: not only because of high fixed costs, but also because it is a non-renewable resource), lower prices reduce production by eliminating production that is not profitable. However, if there is a monopoly or if the producers agree among themselves to limit production in order to increase prices, imposing lowering the price through price controls could even increase production: producers will take the controlled price as a given and produce as much as is profitable at that price since they cannot increase the price by restricting production.

The producers are unambiguously hurt by the price controls since the price is lower. Sure, they can mitigate this effect by changing production. But if they preferred to produce that amount at that price, they could have done it before the price controls. Since they haven’t done it, this means that they prefer their previous position and are hurt by price controls.

Consumers

Benefiting from a lower price was not an option for consumers before price controls. Thus, it cannot be excluded that the consumers benefit from the controls. In fact, consumers lose from these controls only if there is a reduction of production that is so large that the inconvenience of gas shortages more than offsets the gain of paying less for each unit.

Efficiency

If everybody is worse off, we can conclude that price controls reduce economic efficiency. We said that producers are unambiguously hurt by price controls. Thus if consumers benefit from them, we are already in a situation where interests diverge. But let’s assume that the price controls lead to a reduction in production that is large enough for the consumers to be hurt too. At first sight it thus seems that in this case the price controls would be inefficient. But we must make sure to include all impacts on everybody. What about future generations? If less gas is produced today, that leaves more gas for future generations. Thus price controls may be good for future generations. Thus, in this case also, interests may diverge. We cannot assess efficiency without taking a stand on the relative value of the various interests.

The usual stand taken in economics is that a pure transfer does not change global well-being (“pure” in the sense that we have separately taken account of secondary effects like a change in the quantities produced): it doesn’t matter who gets what. Let’s assume first that, in the absence of price control, the price would be such that all gas is produced whose cost is less than its usefulness. Then, introducing price controls will reduce efficiency if the quantity produced changes. Indeed, the consumers’ gain from a lower price on the gas they buy is exactly offset by the producers’ loss on what they sell.  But both consumers and producers lose from reduced production: some gas whose usefulness is greater than its cost is not produced (the benefit could have been shared between consumers and producers). This decreases economic efficiency. However, one has to check that the situation without price controls was efficient (or check that, even if the situation without price controls was not efficient, price controls at the level existing in the late 70’s made matters worse). There are various reasons why the situation without price controls may not be efficient. As discussed previously, competition may for example be imperfect, allowing producers to restrict production in order to increase the price. In this case, price controls may lead to an efficient increase of production (this, however, is not the case if the controlled price is low enough): leading to the production of gas that would not have been produced without price controls although its usefulness is greater than its cost. Another reason involves other sectors than the natural gas market. If for example there is too much unemployment because of an excess demand for money (people and firms want to hold money), then a transfer from producers to consumers may actually help the economy if consumers are more inclined to consume than producers.

Now you can refuse to take the stand that a pure transfer does not change global well-being. You may have more sympathy for one group or another. Maybe some natural gas is imported, and you do not care about the well-being of those foreign producers. Maybe you consider than 1$ in an almost empty pocket will produce more well-being than the same dollar in an already full pocket. Whatever your reason, if you refuse to take the stand that a pure transfer does not change global well-being, you will have to take another stand, and your conclusions may depend on that stand. Even if you conclude that price controls improve economic efficiency in the sense that they increase global well-being as you define it, you may ask yourself if there is another policy that would yield the same result at lower cost, and thus be even better.

Is it true that natural gas price controls during the late 1970s hurt producers at the expense of consumers, but did improve economic efficiency? Sheer logic cannot answer that question. The answer depends on the stand taken as to the weights attributed to the relative worth of the well-being of various individuals. Even if we agree on one stand (for example the usual stand that pure transfer does not change global well-being), then we still need factual information about the natural gas market in the late 70’s. For example, would the situation in the absence of price controls have been inefficient because of imperfect competition, pollution, impact on future generations or for some other reasons? When these are taken into account, the net result depends (in addition to the stand) on the intensity of the various effects (which cannot be assessed without further data).

Why do we work so much?

Why not work less and earn less but have more leisure? Here are some possible answers.

1.       I need the money for current consumption

1.1.              I need the money because I can barely make ends meet at the end of the month

1.2.              I am so much accustomed to my standard of living that it would be highly unpleasant to downgrade it

1.3.              I don’t want to have less than my neighbor

1.4.              I want to have these things they talk about in advertisements

1.5.              All these new products and services that I can buy are worth more to me than the time I spend to earn the money to buy them

2.       I need the money for things other than my current consumption

2.1.              I need the money to save for security

2.2.              I need the money to pay for the education of my children

2.3.              I need money to give it to others

3.       I work a lot now in order to work less later on

3.1.              It is more efficient to work a lot when you have a good job that pays well

3.2.              I work that much to save for earlier retirement

3.3.              I work that much to pay back the mortgage (which will allow me to work less or retire earlier later on since I will have neither rent nor interest to pay)

4.       My work brings me more than meets the eyes

4.1.              I work not so much for today’s salary than for the opportunity to climb higher in the hierarchy (or win the jackpot ) and earn more in the future

4.2.              I love my work

5.       I wouldn’t know what to do with more leisure

5.1.              I couldn’t enjoy more leisure with less money because I need money to travel and to be fit during my leisure

5.2.              I haven’t developed skills for using more leisure

5.3.              I would work less if I could enjoy more time with my friends, but they don’t have time because they work a lot

6.       I do not optimize my work load

6.1.              My employer does not offer part-time employment

6.2.              I just do the same thing as everyone else

Any other ideas?

In considering these motivations, it may be useful to ask the two following questions:

·        How widespread is it?Which of these motivations is actually widespread? What do the empirics say about it? And what does logic say? Is it for example logically possible that everybody works just for fun: in this case why would they be paid?

·        Does this motivation lead to inefficiencies?If everybody works so much only because they want to consume as much as their neighbor, then people would be happier if some brake could be applied to this race. Thus, the motivation to keep up with the Jones’s is bad in the sense that it leads to inefficiencies that might be reduced by an appropriate policy (taxation?).