Working from home and the price elasticity of demand for petrol

The Dangerous Economist (Cyril Morong) had a great post last month on how working from home has affected the price elasticity of demand for petrol (and linking to this (paywalled) Wall Street Journal article). Cyril did an excellent job of outlining factors associated with more elastic demand, but given that my ECONS101 class covered elasticities this week, I thought it might be useful to reiterate some of his points, and add a few of my own.

The price elasticity of demand is the responsiveness of quantity demanded to a change in price. The more that consumers respond to a price change, the more elastic the demand for the good or service is. There are a number of factors that together are the main determinants of the price elasticity of demand. The determinants that I discuss with my ECONS101 class are:

1. The availability of (close) substitutes - having more (or closer) substitutes leads to more elastic demand;
2. The proportion of income spent on the good - if consumers spend a higher proportion of their income on the good, they are more sensitive to its price (more elastic demand);
3. The significance of price in the total cost to the consumer - if the price is a more significant component of the total cost of obtaining the good, then consumers will be more sensitive to the price (more elastic demand);
4. The definition of the market - a narrower definition of the market means that there will be more close substitutes (more elastic demand);
5. Time horizons - consumers who must make their decision quickly are less sensitive to the price (less elastic demand); and if you consider the price change over a longer time period, it will be more elastic (since consumers will have more time to find alternatives); and
6. Normal goods - ceteris paribus, normal goods will have more elastic demand than inferior goods (due to the income and substitution effects working in the same direction for normal goods, but in opposite directions for inferior goods - for a bit more explanation of those effects, see this post).

The first two of those six determinants tend to be the most important.

Now, petrol tends to have relatively inelastic demand, at least in the short run. Consumers don't change their driving habits by much when the price of petrol changes. Maybe they make fewer trips than they otherwise would have, and sometimes walk or bike or take public transport instead. But there are many trips that cannot be replaced by walking, biking, or public transport. In the long run, perhaps consumers could switch to electric vehicles, or move closer to work or school. The adjustment to the amount of petrol demanded is larger in the long run (more elastic).

How does working from home change this picture? When workers can work from home instead of driving into the office, this makes available a new substitute for driving. Working from home is relatively cheaper than driving, so many workers would prefer to work from home, if they can. That makes demand for petrol more elastic. The change in elasticity will be greatest for workers where working from home is a closer substitute to working in the office. That will include workers who don't have to drive towards work for other reasons, such as dropping kids off at school, grocery shopping on the way home, etc.

The current high price of petrol (as a result of the war in Ukraine, and unrelated to working from home (as far as we know)), has probably reinforced the increase in the price elasticity of demand. If petrol is now taking up a higher proportion of household income, demand will tend to be more elastic for that reason as well.

Combining those effects, demand for petrol is more elastic now than it was before the pandemic led to a large increase in working from home.

Curb your enthusiasm for randomised controlled trials

I've often referred to randomised controlled trials (RCTs) as the gold standard for microeconomic research. That's because, when you randomise which units are treated, you can generally extract an unbiased estimate of the causal effect of some intervention or other change that you are trying to evaluate. Other methods of causal inference (that I often refer to on this blog, like instrumental variables, or regression discontinuity) are using careful research designs to try and mimic what you get from an RCT. 

However, despite the boosterism of high-profile economists like Andrew Leigh (whose book, Randomistas, I reviewed here) and Nobel Prize winners Abhijit Banerjee and Esther Duflo (whose book, s Poor Economics, I reviewed here), calling RCTs the gold standard is not without controversy. There are a number of RCT sceptics, one of which is Martin Ravallion (Georgetown University, and previously with the World Bank). I just finished reading this 2018 CGD Working Paper by Ravallion, where he outlines his argument against RCTs (in the context of development, which is the context in which economists most commonly employ RCTs, although they are increasingly common across applied microeconomics). The working paper isn't as anti-RCTs as other critiques, and I think it would be fair to say that Ravallion would simply prefer that people don't overstate what RCTs are capable of, and that researchers wouldn't use them to the exclusion of all alternative methods. As he writes in the conclusion:

We are seeing a welcome shift toward a culture of experimentation in fighting poverty, and addressing other development challenges. RCTs have a place on the menu of tools for this purpose. However, they do not deserve the special status that advocates have given them, and which has so influenced researchers, development agencies, donors and the development community as a whole. To justify a confident ranking of two evaluation designs, we need to know a lot more than the fact that only one of them uses randomization.

The claimed hierarchy of methods, with randomized assignment being deemed inherently superior to observational studies, does not survive close scrutiny...

The questionable claims made about the superiority of RCTs as the “gold standard” have had a distorting influence on the use of impact evaluations to inform development policymaking, given that randomization is only feasible for a non-random subset of policies... The tool is only well suited to a rather narrow range of development policies, and even then it will not address many of the questions that policymakers ask. Advocating RCTs as the best, or even only, scientific method for impact evaluation risks distorting our knowledge base for fighting poverty.

I think the critique is quite measured and reasonably persuasive. However, I doubt it will cause the 'randomistas' to re-evaluate their approach. At best, it might give pause to the broader development community, to think about which contexts are best suited to RCTs, and to adopt other methods in situations where RCTs are less appropriate. In that vein, Ravallion highlights the ethical issues associated with RCTs, which possibly haven't gotten the attention they deserve:

RCTs are also ethically contestable in a way that experimentation using observational studies is not. The ethical case against RCTs cannot be judged properly without assessing the expected benefits from new knowledge, given what is already known. Review boards need to give more attention to the ex-ante case for deliberately withholding an intervention from those who need it, and deliberately giving it to some who do not, for the purpose of learning.

On that last point, it is likely that there are a lot of RCTs undertaken that are, at best, unnecessary, and at worst, possibly unethical. That would be the case where the researchers are already pretty sure that an intervention has a positive effect, and the RCT is being employed to see how big the effect is, rather than whether there is any effect at all. In that case, withholding the intervention from the control group is exposing them to worse outcomes (however measured), simply for research purposes. On the other hand, there are genuine cases where an intervention can't be rolled out to everyone who is eligible, because of resource constraints. That might overcome the ethical issues to some extent. These are some curly questions there that ethics committees should be paying more attention to.

Ravallion hasn't changed my mind about the 'gold standard' nature of RCTs. I already recognised that there were many contexts where RCTs are impractical and other methods should be employed, or where randomisation cannot be strictly adhered to. In those contexts, a mix of alternative methods are available. Your views may well be different. Regardless, the points that Ravallion raises should temper any enthusiasm for RCTs.

Remote work, wages, and compensating differentials

The labour market has undergone a massive upheaval since the pandemic, with the sudden shift to remote work, which has persisted even as the pandemic's effects wane. Or rather, some but not all sectors of the labour market have seen a sudden shift to remote work - I am yet to see a remote barista, for instance. Why has remote work persisted (in some sectors)? Clearly, this only happens if both workers and employers benefit. That is part of the premise of this new NBER Working Paper (ungated version here) by Jose Maria Barrero (Instituto Tecnologico Autonomo de Mexico) and co-authors.

Barrero et al. are focused on the effect of remote work on wage pressures. However, I think there is a more interesting story that sits alongside it, in relation to compensating wage differentials. Barrero et al. note that:

In equilibrium, workers and employers share the amenity-value gains arising from the shift to remote work. Since workers reap the direct benefits of the shift at any given wage, employer benefits take the form of wage-growth restraint during the transition to a new equilibrium with compensation packages that reflect the greater amenity value of higher remote work levels...The Nash bargaining benchmark, for example, says employers get half the surplus created by the rise of remote work.

This relates closely to search models of the labour market, where the surplus generated from a successful match between an employer and a worker is shared between both parties. The shares of the surplus that employer and worker receive depend on their relative bargaining power. In this case, remote work generates an additional surplus, which is shared between employer and worker. That additional surplus may arise from higher productivity of the worker at home, or from the worker spending more hours working (because they spend fewer hours commuting), or because the employer has to spend less on the work environment (because fewer employees are there on any given day, which this earlier post notes has also had an effect on the market for office real estate). How is this additional surplus shared? The additional value of production (or cost savings) are only partially passed onto the worker by the employer. The employer keeps a share for themselves.

This means that, although wages go up, they don't go up by as much as the additional value that is generated. This relates to the idea of a compensating differential, because workers are happy to accept a lower wage (or a lower increase in wages) when their job has positive non-monetary characteristics. To the extent that working from home is a positive non-monetary characteristic, workers would therefore accept a lower wage if their job includes more working from home.

And that is essentially what Barrero et al. find, using data from the Survey of Business Uncertainty (SBU) in April and May 2022. Specifically, they asked:

...each business executive in the SBU the following question: “Over the past 12 months, has your firm expanded the opportunities to work from home (or other remote locations) as a way to keep employees happy and to moderate wage-growth pressures?” According to the responses, 38 percent of firms did so in the previous 12 months... larger firms and firms in... Education, Healthcare & Social Assistance or in FIRE, Professional & Business Services, and Information are more likely to moderate wage-growth pressures by expanding remote work opportunities...

...we also ask: “Over the next 12 months, will your firm let employees work from home (or other remote locations) at least one day per week to restrain wage-growth pressures?” Forty-one percent of business executives respond “yes” to this question... the pattern of responses by firm size and across industry sectors to this forward-looking question is very similar to the response pattern for the backward-looking question. 

Notice that the sectors that report high degrees of remote work are those that you mostly would expect (although healthcare may be a bit of a surprise, but there are a lot of administrative staff in that sector, and some primary healthcare can be delivered remotely). Barrero then ask about how much the firms can (or have) restrained wage growth, and find that:

On a size-weighted basis, we estimate that expanded remote-work opportunities moderated overall wage-growth pressures by 0.9 (0.1) percentage points over the 12-month period ending in April/May 2022. Looking forward, we estimate that expanded remote-work opportunities will moderate wage-growth pressures by another 1.1 (0.1) percentage points in the 12 months following April/May 2022. These estimates have good precision, as indicated by the standard errors reported in parentheses.

Notice that remove work has reduced the extent to which firms are increasing wages (at least, as reported by the firms themselves). And by sector:

Over the two years centered on April/May 2022, the unweighted mean wage-growth moderation effect is 1.3 percentage points among Goods Producers and 1.4 points among firms in Trade, Transportation & Warehousing, and Leisure & Hospitality. These sectors offer relatively few jobs that can be readily performed in remote mode. In contrast, the mean wage-growth moderation effect over two years is 2.7 points in Education, Healthcare, Social Services and Other Services and 3.0 percentage points in FIRE, Professional & Business Services and Information. Except for Healthcare, these sectors have a relatively high share of jobs that can be performed in remote mode...

This provides some evidence that it is remote work driving the lower wage increases, since the effects are greatest in sectors where remote work has become more common. Finally:

We also draw out two other interesting implications of our evidence. First, we estimate that the amenity-value shock associated with the recent rise of remote work lowers labor’s share of national income by 1.1 percentage points. Second, we provide evidence that the “unexpected compression” in the wage distribution since early 2020 is partly explained by the same amenity-value shock, which operates differentially across the earnings distribution.

In other words, the shift to remote work and the compensating differential will have some interesting effects on the measurement of inequality. The labour share of income, which many people equate with a measure of inequality between workers and owners of capital, will decrease. However, because most remote work jobs are relatively high-earning jobs, their smaller wage increases relative to lower-earning non-remote-work jobs will tend to decrease measured income inequality.

No doubt some governments will pat themselves on the back if inequality appears to decrease. However, it's not really much of an improvement if income inequality is reducing, but only because the non-monetary job characteristics of those at the top of the income distribution are improving. This highlights one of the limitations of income inequality as a measure of differences in personal wellbeing.

However, that isn't the story that Barrera et al. are trying to tell in their paper. They conclude that:

...the recent rise of remote work materially lessens wage-growth pressures. In doing so, the rise of remote work eases the challenge confronting monetary policy makers in their efforts to bring the inflation rate down to acceptable levels without stalling economic growth.

I guess that may be some good news. To the extent that remote work persists, and to the extent that central bankers are paying attention, we might expect that interest rates may not have to increase as much in order to bring inflation back under control.

[HT: Marginal Revolution] 

A radical proposal for reframing Econ101 from a sustainability perspective

I don't teach a 'traditional' economics principles course, even though I teach two papers at first-year university level. One of my papers teaches business economics, so focuses on business applications and has more game theory, pricing and competitive strategy than you would see in a principles paper. It also uses the CORE textbook, which is not a traditional principles text (but is also not designed explicitly to teach business economics, so a lot of what we do is outside of the textbook). The other paper I teach is Economics and Society, which is more of a survey paper, covering economic policy using microeconomic principles. It still isn't a principles paper though, as we do a lot of things that are well outside of a principles curriculum, like property rights, the economics of education, health economics, and the economics of social security. It is more like a welfare economics paper, but without the heavy maths that welfare economics usually entails.

Given that I don't teach a traditional course, and don't follow textbooks too closely, I am always on the lookout for new ideas on how to reframe parts of my papers. So, I was interested to read this 2020 article by Inge Røpke (Aalborg University), published in the journal Ecological Economics (ungated earlier version here). Røpke proposes a new structure and content for Econ101, with a focus on sustainability and a grounding in ecological and heterodox economics.

This long quote from the conclusion of the article captures the main ideas:

The proposed knowledge structure involves a delimitation of economics with a focus on provisioning: how do humans make a living? This provides a specific cut through the totality, which is always both biophysical and social. The fundamental thought patterns of the approach include the bridging of the structure-actor interplay and related concepts of institutions and power, conceptualization of dynamics based on evolutionary thinking and systems thinking, and the idea that agents’ own reflexive understandings are an integral part of development. Turning to the substantive issues of economics, the introductory topics include thermodynamics, ecology, the energy history of humans, basic ideas from earth system science, and the idea of social metabolism. Provisioning is introduced as a broad concept that captures all sorts of contributions of goods and services to the real cake that is available for consumption and investment. Provisioning is seen as a human activity where the practitioners provide the result, while ownership of the tools involved is not considered a productive force. Due to the condition of incommensurability, the size of the real cake cannot be measured in any meaningful way. As the present distribution of the cake is based on a long history, it is necessary to give a brief outline of the emergence and development of capitalist institutions. This should include the importance of property relations for distribution, the emergence of markets and their dependence on government, the changing character of market participants, the dynamics and instability of capitalism, as well as the global reach of capitalism. Turning to distribution, it is important to emphasize the lack of connection between the individuals’ efforts to provide the cake and their access to appropriate parts of it. Access is achieved through conventions related to care, through rights and purchasing power, which is acquired as salaries and, even more, in the form of rent related to property institutions. Prices serve as a distributional mechanism, but cannot be considered relevant measures of value. Finally, the introduction to governance challenges rigid means-ends rationality, but acknowledges the need for making the world understandable and governable through various devices. Biophysical and social measures are preferable to monetary assessments, and deliberative methods are promoted as means to provide inputs to political decision-making. Regarding actual strategies, the need for conscious construction of markets is emphasized as well as a navigational approach to sustainability transitions.

This knowledge structure can be used as a framework and basis for adding insights from both heterodox and mainstream economic thinking, but it replaces the mainstream focus on market exchange as the key topic of economics and it dismisses, for instance, the concepts of equilibrium, optimality, efficiency, choice between given alternatives, and money as a measure of value. Such concepts and the related neoclassical framework can be introduced at a relatively late stage as a way in which various actors perceive the world.

I'm open to some (but not all) of the ideas that Røpke is suggesting. In fact, some of the things she suggests are already embedded within my papers. However, in the article she critiques such an incremental approach, as well as the idea that heterodox approaches should be seen as simply an extension or counterpoint to mainstream views.

However, while Røpke may be able to convince individual lecturers, that may not be enough. Making a big change to an introductory course cannot be done in isolation, and will require buy-in from across a department. Lecturers in intermediate microeconomics are not going to be happy when some of the assumed knowledge about market equilibrium is absent from their incoming students' first-year experience. Rebuilding the foundations of the economics curriculum in introductory principles necessitates changes across the economics major. Needless to say, that is a huge undertaking, and may not attract universal buy-in from all members of the faculty. That isn't a reason not to make these changes, just a statement of the difficulty of doing so.

Also, it would be interesting to know whether there is sufficient demand from employers for this alternative approach. Some employers no doubt expect economics graduates to have been trained in a conventional, neoclassical framework, with some additional perspectives set alongside it. I imagine that is what the banks and finance companies who employ a large proportion of our graduates expect. Would they be equally happy with a student who has a heterodox foundation? I honestly have no idea, but it would be worth exploring this before embarking on a major overhaul of the curriculum.

Traditional economics principles has undergone some significant changes in recent years. The CORE textbook is one example, although whether CORE is an improvement is contested, while others believe that it does not go far enough. My own view is that a radical revision of introductory economics may be unnecessary or unwelcome. A continuing process of improvement, incorporating further insights from new institutional economics, game theory, behavioural economics, experimental economics, ecological economics and other fields, is probably the optimal approach.