Tuesday, 19 September 2017

Book Review: Inequality - What Can Be Done?

Earlier this month, I finished reading "Inequality - What Can Be Done?" by the late Tony Atkinson, who sadly died at the start of the year. This book is thoroughly researched (as one might expect given it was written by one of the true leaders of the field) and well written, although the generalist reader might find some of it pretty heavy going. The book is also fairly Britain-centric, which is to be expected given that it has a policy focus, although there is plenty for U.S. readers as well. Unfortunately for those closer to my home, New Zealand rates only a few mentions.

Atkinson uses the book to outline his policy prescription for dealing with inequality (hence the second part of the title: "What can be done?"). This involves fifteen proposals, and five 'ideas to pursue'. I'm not going to go through all of the proposals, but will note that many of them are unsurprising. Others are clearly suitable for Britain, but would take much more work to be implemented in a different institutional context (that isn't to say that they wouldn't work in other contexts, only that they would be even more difficult to implement).

Atkinson also isn't shy about the difficulties with his proposals and the criticisms they might attract, and he addresses most of the key criticisms in the later chapters of the book. However, in spite of those later chapters, I can see some problems with some of the proposals that make me doubt whether they are feasible (individually, or as part of an overall package). For instance, Proposal #3 is "The government should adopt an explicit target for preventing and reducing unemployment and underpin this ambition by offering guaranteed public employment at the minimum wage to those who seek it". These sorts of guaranteed employment schemes sound like a good solution to unemployment on the surface, but they don't come without cost. I'm not just talking about the monetary cost to government of paying people the guaranteed wage. This guaranteed employment offer from the government might crowd out low-paying private sector employment, depending on the jobs that are on offer. Minimum-wage-level jobs are already unattractive for many people to work (consider the shortage of workers willing to work in the aged care sector, even though there are many unemployed people available for such jobs). So in order to encourage the unemployed to take up the guaranteed work offer, these jobs would need to be more attractive than existing minimum-wage-level jobs in other ways. Maybe they will require less physical or mental effort, or maybe they will have hours of work that are more flexible or suitable for parents with young children. These non-monetary characteristics would encourage more of the unemployed to take up the guaranteed employment offer, but they might also induce workers in other minimum-wage-level jobs to become 'unemployed' in order to shift to the more attractive guaranteed work instead. Maybe. The system would need to be very carefully designed, and I don't think Atkinson fully worked through the incentive effects on this one.

Proposal #4 advocates for a living wage, which I've already pointed out only works well when not all employers offer the living wage, but a higher minimum wage would simply lower employment, as the latest evidence appears to show. Proposal #7 is to set up a public 'Investment Authority' (that is, a sovereign wealth fund) to invest in companies and property on behalf of the state, but the link to inequality reduction of this proposal is pretty tenuous. In his justification for this proposal, I felt the focus on net public assets being a problem ignores the value to the government of the ability to levy future taxes, which is very valuable So, it's not clear to me that low (or negative) net public assets are necessarily a problem that needs solving.

Finally, it is Proposal #15 that is most problematic for the book: "Rich countries should raise their target for Official Development Assistance to 1 per cent of Gross National Income". I'm not arguing against the proposal per se (in fact, I agree that rich country governments should be providing more development aid to poorer countries). But if the goal of these proposals is to reduce inequality in Britain, this proposal would have at best no effect. If the goal instead is to reduce global inequality, the policy prescription is quite different, and could be more effectively achieved by avoiding most (if not all) of the other proposals put forward in the book, and simply raising the goal in Proposal #15 from 1 percent to 2 percent of Gross National Income, or 3 percent, or 5 percent. None of the other proposals would be as cost-effective in reducing global inequality as would increasing development aid.

That's about all my gripes about the book (note that they only relate to four of the fifteen proposals). Overall it is worth reading and I'm sure most people will find some things to take away from it. I certainly have a big page of notes, that I'll be using to revise the inequality and social security topic for my ECON110 class that's coming up in a couple of weeks. Especially, there is an excellent discussion that explains changes in inequality over time, and especially the increases in inequality that have happened across many countries since 1980 (this is an interesting place to start, since the time period then covers the period in the 1980s through to the mid-1990s, when inequality really was increasing in New Zealand).

If you're looking for an easy introduction to the economics of inequality, this probably isn't the book for you. But if you're looking for a policy prescription, or ideas on policy, to deal with the problems of inequality, then this may be a good place to start.

Sunday, 17 September 2017

The Greens vs. Labour on carbon emissions, taxes and permits

Brian Fallow wrote an interesting article in the New Zealand Herald on Friday, contrasting the climate policies of Labour and the Greens. It was doubly interesting given that we had just covered this topic in ECON110 last week. Here's what Fallow wrote:
The climate change policies the two parties have recently released overlap a lot, in ways that distinguish them from National and the status quo.
But they are also at odds over which is the better way to put a price on emissions that will influence behaviour in the economy.
Labour wants to restore the emissions trading scheme (ETS), as designed by David Parker and enacted by the fifth Labour Government in the last few weeks of its ninth year in power, then promptly gutted by the incoming National Government.
But the Greens favour a tax on emissions, the proceeds of which would be used to plant trees on erosion-prone land, and the rest (most of it) recycled as an annual payment to everyone over the age of 18.
Pigovian taxes (e.g. a tax on carbon emissions) and tradeable pollution permits (e.g. the emissions trading scheme) are essentially two ways of arriving at the same destination - a reduction in emissions. Consider the diagram below, which represents a simple model for the optimal quantity of pollution (or carbon emissions). The MDC curve is the marginal damage cost (the cost to the environment of each additional unit of carbon emitted) and is upward sloping - this is because at low levels of carbon emissions, there is relatively less damage because the environment is able to absorb it. The capacity for the environment to do this is limited, so as carbon emissions increase the damage increases at an accelerated rate. The MAC curve is the marginal abatement cost (the cost to society of each unit of carbon emissions abated, or reduced) and is upward sloping from right to left. This is because, as more resources are applied to reducing carbon emissions, the opportunity costs increase. This may be because less suitable resources (meaning more costly resources) have to begin to be applied to pollution reduction. The optimal quantity of carbon emissions occurs where the MDC and MAC curves intersect - at Q*. Having less carbon emissions than Q* (such as at Q1) means that MAC is greater than MDC. In other words, the cost to society of reducing that last unit of carbon emissions was greater than the cost in terms of environmental damage. Having pollution at Q1 must make us worse off when compared with Q*.


The diagram illustrates that there are two ways of arriving at the optimal quantity of carbon emissions. One way is to regulate the quantity of emissions to be equal to Q*, as you would in an emissions trading scheme. You allocate carbon permits equal to exactly Q*, and legislate that no one is allowed to emit carbon unless they have permits (and have appropriately large penalties in place for those that break the rules).

An alternative is to price emissions at P*, as you would through a carbon tax. If the price of emissions is P*, you will have exactly Q* emissions. This is because no one would want to emit more than Q*, because the MAC is lower than the tax they would have to may (so it is cheaper to abate one unit of carbon emissions than it is to pay the tax, so at quantities above Q* the quantity of emissions would reduce). Similarly no one would want to emit less than Q*, because the MAC is greater than the tax (so it is cheaper to emit one more unit of carbon and pay the tax, rather than pay the cost of abating that unit).

Which should we prefer - an emissions tax, or an emissions trading scheme? There are arguments for and against either (as I have noted before). Neither system is particularly flexible if new cleaner technology becomes available. Both provide incentives to reduce carbon emissions to Q* (and no further). Taxes may be less subject to corrupt practices (such as in deciding who would get any initial allocation of permits). Permits may be more efficient in the economic sense, since the emitters who can reduce their emissions at the lowest cost would sell their permits to those who can only reduce emissions at high cost.

Fallow doesn't conclude that either system is better though. However, one thing is clear, and that is that all countries doing nothing about carbon emissions is unambiguously worse than either system. And both emissions taxes and emissions trading schemes are better than old-school command-and-control regulation.

Read more:

Saturday, 16 September 2017

Should trade unions be subsidised?

An externality is defined as an uncompensated impact of the actions of one person on the wellbeing of a third party. A positive externality is an externality that makes the third party better off. This creates a problem because the person creating the positive externality has no incentive to take into account the fact that they also creates benefits for other people. This leads to a situation where the market produces too little of a good, relative to the quantity that would maximise total wellbeing (or total welfare).

This is illustrated in the diagram below, which shows a positive consumption externality. The marginal social benefits (MSB - the benefits that society receives when people consume the good) are greater than the marginal private benefits (MPB - the benefits that the individual receives themselves by consuming the good). The difference is the marginal external benefits (MEB - the benefits that others receive when a person consumes the good). The market will operate at the quantity where supply meets demand, which is QM on the diagram. However, total welfare is maximised at the quantity where marginal social benefit is equal to marginal social cost, which is QS on the diagram. The market produces too little of this good, because every unit beyond QM (and up to QS) would provide more additional benefit for society (MSB) than what it costs society to produce (MSC). However, the buyers have no incentive to take into account those external benefits, so they don't consume enough.


What does that have to do with trade unions (as in the title of this post)? When a person belongs to a trade union, that provides them with some private benefit (MPB) - they can call on the union if they have a problem with their employer, they can use the union to negotiate for better pay and conditions on their behalf, and so on. However, a person's union membership also creates benefits for others (MEB), because the more people who are union members, the more negotiating power the union will have. So, it seems clear that in the case of unions, the marginal social benefits exceed the marginal private benefits, and the market for union membership will lead to too few people being members of trade unions (just as in the diagram above).

When a positive externality leads a market to produce too little of a good, we could rely on the Coase Theorem, which suggests that when private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. In the case of unions, the Coase Theorem suggests that employees should be able to develop a solution to the externality that leads to the 'right' number of people becoming union members. However, the Coase Theorem relies on transaction costs being small, which is not the case when there are a large number of parties involved (which is the case when there are many employees). If the Coase Theorem fails, then that leaves a role for government.

Public solutions to a positive externality problem could be based on a command-and-control policy. That is, a policy that regulates the quantity. Compulsory union membership would be a potential command-and-control solution to the positive externality problem, but it seems unlikely that the quantity QS in the diagram above is equal to (or more than) every person belonging to a union.

In most cases of positive externalities, the government relies on a market-based solution to positive externality problems, such as providing a subsidy. The effect of a subsidy on the market is illustrated in the diagram below. The curve S-subsidy illustrates the effect of paying a subsidy to the trade union for every union member (you could achieve the same effect by partially reimbursing every union member - a subsidy on the demand side of the market). This lowers the price of union membership for members to PC (which incentivises more people to join the union), and raises the effective price for the unions to PP. The quantity of union membership increases to QS, which is the optimal quantity of union membership.


Many governments like to subsidise their favoured sectors of the economy, even though that lowers total welfare. Perhaps they should be looking to subsidise trade unions instead?

Friday, 15 September 2017

Lottery tickets and the endowment effect

Behavioural economics teaches us that people are not purely rational. The behavioural economist Richard Thaler notes that people are quasi-rational, which means that they are affected by heuristics and biases. One of the biases that we are affected by is loss aversion - we value losses much more than otherwise-equivalent gains. That makes us are unwilling to give up something that we already have, or in other words we require more in compensation to give it up than what we would have been willing to pay to obtain it in the first place. So if we buy something for $10 that we were willing to pay $20 for, we may choose not to re-sell it even if someone offers us $30 for it. We call this an endowment effect.

As a graphic illustration of endowment effects, and timely given that Lotto Powerball in New Zealand jackpots to $30 million this weekend, take this recent video from Business Insider:


Most of the people in the video were unwilling to give up their Powerball tickets for what they paid for them, or even for double what they paid for them (after which, they could have bought twice as many Powerball tickets and doubled their chances of winning). Crazy.

[HT: Marginal Revolution]