Maxine Udall (girl economist)

Memorial Giving in Honor of Alison Snow Jones

For those who would like to make a gift in Alison's memory to please consider giving to the FaithTrust Institute or the Alison Snow Jones Memorial Fund at Drexel University.  If giving online to Drexel University, please be sure to add "Alison Snow Jones Memorial Fund" in the special instructions field.  Call Ray Slater, the director of development at the School of Public Health, at (215) 762-8437 for more information.

-David Pinney, Meredith Frost

To all Maxine Udall Girl Economist readers

It is with great sadness that we bring you the news that Dr. Alison Snow Jones, aka Maxine Udall (Girl Economist), died of an apparent heart attack at home on January 17, 2011. "What Price Microfinance" was her last post.

Dr. Jones received her Ph.D. in Health Economics from Johns Hopkins School of Hygiene and Public  Health (now Bloomberg School of Public Health). She served on the faculty of Johns Hopkins and later Wake Forest School of Medicine. Her last position was at Drexel University where she headed a joint program between the Schools of Business and Public Health. Those of you familiar with this blog know that she was strong believer in capitalism, but espoused an infusion of morality in business behavior and education.

In order to honor her writing, her courage in tackling difficult issues with clarity and grace, her varied and passionate interests, her love for people in all walks in life, and her many fans, we will keep this blog online. You can still comment on any post. We will share information here on where you can contribute to her memorial fund as it becomes available.

Please read, link to, and mine Dr. Jones's writing for information, insight and inspiration. Her deepest hope was to challenge people to think in new ways about our society and how we live, and to bring her unique viewpoint to as many people as possible. I think she has succeeded.

Dr. Jones loved writing and was brimming with new ideas and enthusiasm. She was happiest when crafting another blog post as Maxine Udall.

She will be sorely missed.

Warmest regards,
David Pinney, Meredith Frost

What Price Microfinance?

Martin Luther King Day seems like a good day to write about microfinance.

A couple years ago I heard Vikram Akula speak at a top graduate business school about his for-profit micro-finance firm in India, SKS. The talk was held in a large lecture hall, probably seating at least 250. The talk was held after the Lehman collapse. One of the remarkable things I remember about the talk was that it was standing room only and many, many future MBAs were standing to hear it. Another remarkable thing I remember was that Akula asserted during his talk that his managers and workers were paid something on the order of 20% less than they could make in more traditional finance firms. I remember him saying that the rationale for this was that he wanted people who were interested in doing good, not just in making money. At least, this is how I remember it.

But the most remarkable thing I remember about his talk was that when it was done, he fielded question after question from different members of the audience, all on a theme of "how do I come work for SKS?" Even at only 80 cents on the MBA starting salary dollar, a lot of the audience wanted to come work for SKS.

I suppose they might have been asking that last question because at the time and for a multitude of reasons traditional finance wasn't looking like an attractive career option. But I think not. Most of the future MBAs phrased their questions in ways that suggested that the draw was putting their skills and talents to work doing some good in the world. And they were willing to work for less to do this.

This is not news. Economist Robert Frank provided evidence some years ago that people are willing to work for less when they believe they are doing some good in the world. (As an aside, I will point out that this phenomenon is entirely consistent with utility maximization, but not with maximization of indirect indicators of utility, such as income).

A couple weeks ago, my friends and readers began sending me links to articles about "beneficiaries" of micro-finance in India resorting to suicide when their indebtedness became overwhelming. More recently, Muhammad Yunus, micro-finance originator and Nobel Peace Prize winner, weighed in with this condemnation of for-profit micro-finance. This was followed by a fairly predictable response from the Philanthrocapitalism blog making the usual arguments in support of for-profit micro-finance and this more nuanced and thoughtful response by Felix Salmon.

Salmon does an outstanding job of critiquing the Philanthrocapitalism blog, so I'm not going to re-cover that territory. But I have a couple of observations.

The first is that, personally, I like the idea of micro credit. Availability of credit at a reasonable interest rate seems to be the main difference between me and a lot of less well-off people. Something unexpected happens that makes a temporary hole in my income, I have resources. I can borrow to fill it. It requires me to give up some future income to repay it, but that's a lot better than having to sell everything and start over again. The fact that micro credit often is used to increase economic self-sufficiency by funding entrepreneurship is an even stronger argument in favor of it. If it lifts people out of poverty in a sustainable way, it's hard to find fault.

Unless the people it is lifting are not those in poverty, but those who already own plenty of capital and want to own more (at the expense of those they purport to be lifting). And there's the rub.

Look, I'm only going to repeat this a few more times: the higher the returns, the higher the risk.

If micro-financiers have to charge higher interest rates, it's because they're making riskier loans to people who probably should not be receiving them. I'm sorry. I know it's harsh, but that's the reality. There are probably some people who should not receive loans, especially if one desires to make a profit. Those people should receive gifts. Yes, gifts. Not loans, gifts. Subsidies, transfers, job training, education. Gifts.

Or, if micro-financiers have to charge higher interest rates, they're employing people who want to make money rather than people (willing to work for 20% less) to do good. There are probably some people who should not be in micro-finance either as investors or as employees. Those for whom only money matters.

So. If you're in the micro-finance business to make money, you should probably resign yourself (like those MBA students I described above) to making less money. You will have entered into a business where it is not OK to shift risk to those least able to bear it. You will have entered a business with dual objectives and one of them imposes an ethical contraint on your returns.

You get to charge higher interest rates because your clientele are high-risk, but you don't get to lend to just anyone regardless of their ability to pay and then claim that you're doing good by making credit available to more people. Nor do you get to charge any old interest rate you feel like charging. Yunus is right. It should be tied to your underlying fund costs. Anything in excess of the 15 percentage point spread between fund costs and interest charged that he describes can only be justified by increased risk, which neither lenders nor borrowers should be taking on. Especially already impoverished borrowers.

Spreads in excess of Yunus' 15 percentage points for for-profit micro-financiers can only signal either too much risk or too much profit. Either way, it's too much when the dual objective is profits and lifting people sustainably out of poverty.

Failure to recognize the above and to structure micro-finance responsibly to achieve the twin goals would put micro-financiers in the same ignominious company as sub-prime lenders, liar and interest-only loans, and all the wonderful, creative, entrepreneurial guys who gave us our current economic recession.

Leading indicators that risk and/or profits are too high would include increasing reports of suicide among your "clientele." It's a sure sign that investors have rigged the game too much in their own favor. It would be a Good Thing to find another, less final leading indicator and provide pre-emptive remedy before people start dying. I'm willing to bet that the borrowers most likely to kill themselves are also the ones most likely to want to pay back their loans. Not a selection effect an investor should want to encourage.

The price of the moral high ground isn't high, but neither are the profits associated with it. Those who occupy it are willing to work for less. Those who invest in it should be willing to accept lower returns on their capital, knowing that the rewards are more than monetary and the risks, for both lender and borrower, are less variable and more sustainable. That makes borrowers, lenders, investors, and the rest of us, all, better off.

A "Must Read" on the Original Mandate of the Fed

From the always thoughtful and insightful, Rajiv Sethi, this is the best thing I've read on the Fed and TARP to date. Read it here.

Economics: Art or Science?

Last week a good friend emailed me this NY Times opinion piece by David Brooks. I'm not a big fan of Brooks, but I think this is worth weighing in on because I fear it may be the beginning of a concerted effort to discredit economics just as we teeter on the verge of an important course correction.

The text supplied by the NY Times under the link in the email read:

After the crash, economics will have to acknowledge its methodological failures and come to resemble an art rather than a science.

Gosh, I hope not.

Brook's article is pretty apocalyptic stuff. Here are his final incendiary paragraphs:

...economists are taking baby steps into the world of emotion, social relationships, imagination, love and virtue. In Act V, I predict, they will blow up their whole field.

Economics achieved coherence as a science by amputating most of human nature. Now economists are starting with those parts of emotional life that they can count and model (the activities that make them economists). But once they’re in this terrain, they’ll surely find that the processes that make up the inner life are not amenable to the methodologies of social science. The moral and social yearnings of fully realized human beings are not reducible to universal laws and cannot be studied like physics.

Once this is accepted, economics would again become a subsection of history and moral philosophy. It will be a powerful language for analyzing certain sorts of activity. Economists will be able to describe how some people acted in some specific contexts. They will be able to draw out some suggestive lessons to keep in mind while thinking about other people and other contexts — just as historians, psychologists and novelists do.

At the end of Act V, economics will be realistic, but it will be an art, not a science.

Blow up their field??? Spoken like someone who doesn't understand the science or the math or the value of either.

Let me give you an example.

Several years ago, I found myself among a group of bioethicists, most of whom seemed frankly hostile to economists. One of the issues that was paramount in their discussions was the ethical allocation of scarce resources. While they were mostly concerned about what I think of as "bedside" ethics, they were grappling with a recurring issue on the nation's health agenda: the elimination of health disparities.

One recurring phrase was we need to "maximize societal health." They seemed to think this would involve giving more health producing inputs to health disadvantaged people. It seemed almost nonsensical to me for several reasons. First, if I wanted to "maximize societal health," I would allocate more resources to the people who were most efficient and effective at producing health, those whose marginal product from the resources is highest. Assuming that people who are more efficient at producing health are also more efficient at producing wealth (and vice versa), this would almost certainly mean that I would be giving more health producing resources to higher income people who are already healthier, not necessarily those whose health is least good.

That comes out of the math.

So whatever it is they want to do, it's probably going to be more complex than a simple transfer of resources. Knowing something about the math might have helped them think about this. And if they really meant what they said, they would probably end up denying resources to some who ethically should have them. I don't think "maximizing societal health" means what they think it means, at least in the short-run.

To be fair, they all understood the complexities of what they wanted to do, and most understood that one of the things that must happen is that those with low marginal product of health need to be helped to become more efficient and effective at producing health. They also understood that resources should be directed where marginal product was likely to be highest, regardless of ability to pay. But as long as there is heterogeneity in health production, "maximizing societal health" will allocate more resources to those who are best at producing health, probably the healthiest.

Another thing that comes out of the math is that if I take resources away from health advantaged people in order to give them to health disadvantaged people, the health advantaged people will be harmed, at least in terms of their level of health. This has ethical implications, unless of course, there is some region of the health production function where marginal product is negative for the most healthy. This could occur if the health advantaged have managed to capture more than the optimal allocation of health producing resources. Then taking some away from them and giving the resources to the health disadvantaged would make everyone healthier and would "maximize societal health." Win-win.

Unfortunately, the production of health is complex. Environment, nutrition, education,  and exercise matter as much if not more than medical care. So it probably matters which resources you re-allocate. It most likely won't be enough to re-allocate just medical care.

That comes out of the math and the theory.

It comes out of the theory because we as a society probably don't want to maximize societal health anymore than most of you reading this are "maximizing" your own health. Instead, you're maximizing something, known only to you, that provides you with what you judge to be a "good life." It is a combination of work, education, health care, nutrition, leisure, relationships, and, for some of you, tobacco, alcohol, and drugs. (The last three might actually harm your health.) We economists call what you're maximizing "utility." Utility can be thought of as happiness or satisfaction. We call it "utility" because the term implies something a bit more complicated than short-sighted pleasures. In its original sense, there was a sense of virtue or interconnectedness with others that would imply a brake on pure hedonism in it's shortsighted modern sense. Implicit in this conceptualization is the notion that you are the best judge of what gives you utility and that you have all the information you need to make that judgement.

What we might want to maximize then is the sum of all our utilities, which is one way to think of maximizing societal well-being. It turns out it's difficult to figure out how to do this. So instead we could assume that societal well-being is indirectly reflected by the value of the total amount of a nationally produced mixture of publicly provided goods and services and privately provided goods and services. If we were to adopt this proxy measure of societal well-being, we would want that "mixture" and the amounts to match pretty accurately people's preferences and everything that yields benefits or harms to them.

It turns out that if private markets are competitive (i.e., no externalities, no information asymmetries, no agency problems, many small firms, etc), they will provide the mixture and amounts that match people's preferences. If those preferences map accurately to individual utility (and rightly or wrongly, economists assume they do under certain conditions), societal "utility" or well-being will be maximized.

There's a problem though. For many of our most important privately produced goods and services, say, health care and financial services, the conditions for perfect competition are not even close to being met. So we can't be sure that the right (societal utility maximizing) amounts and mix of those services are being produced. This means that our proxy measure of societal well-being will not accurately correspond to actual well-being.

Other important private goods and services, like mother's milk and child or elder care by (unpaid) family caregivers, aren't traded in markets, which makes it very difficult to measure the valued-added by maternal and family caregiver time and effort (what they add over and above the final goods and services they purchase to provide the unpaid services). For this reason, their contribution to societal well-being will not be accurately reflected in our proxy measure of societal well-being.

And then there are public goods, like clean air and water, disease control, national defense, and public recreational facilities. In the absence of markets, it's difficult to know for sure what mix and amount of public goods will "maximize societal well-being." If our political process does not yield the socially optimal amount of final goods and services used to produce these public goods, it will tend to bias the correspondence between our proxy measure and actual societal well-being. This is one reason why it is so important to have a well-functioning political system and an informed electorate.

For these reasons, "perfect competition" in private markets does not solve all of society's allocation problems nor does GDP (a measure of national output) accurately reflect societal well-being. Most economists know all of this and some are attempting to develop better measures of national well-being.

The point of all this is to say that much of the science of economics is quite sound and quite useful for informing public policy. Recent events in the financial sector have stimulated much needed soul searching in macroeconomics, but that doesn't mean the whole discipline is wrong or corrupt. Nor does it mean that all macroeconomists are fools. Some of them got it right and continue to get it right. Even those who got it wrong are entitled to be wrong. Scientists make mistakes. When they learn they have made a mistake, they revise their theories. It's an important feature of "science."

If there is a flaw in the science and math of economics, I believe it is in the narrow ways we have tended to conceptualize and relate our theories to real-world phenomena. I think that Brooks is right that we have tended to downplay externalities of affect or commitment. We have also tended to be uncritical about the normative meanings of our positive assumptions. For example, we tend to assume that a household's budget constraint is endogenous in hours worked and that workers are paid their marginal revenue product and that therefore wages (and profits and household incomes) are always and everywhere just. And we have tended to assume separability of consumption bundles even among those whose incomes are so low that they are substituting heat for food and food for children's health care.

I don't know that these positive assumptions are necessarily fatal in accurately estimating average effects (causal or otherwise), but I frequently worry that public policy based on them may be fatal (literally fatal) to some groups (groups that are not average) that the policies purport to help. That has normative implications.

Another empirical and merely technical issue I worry about is our strong preference for instrumental variables methods when a policy variable of interest is self-chosen or otherwise correlated with the error term. These methods frequently yield purportedly unbiased, but often highly imprecise estimates. As the limitations of instrumental variables have become more apparent, instead of trying to "fill in" the unobservables, we have resorted to ever more complex "instruments" derived from so-called "natural experiments" that yield "instruments" that may or may not be exogenous and that produce results that may or may not be unbiased estimates of causal effects. Then we make public policy recommendations based on the results without regard for the possibility that human lives and well-being hang on the accuracy and precision of those estimates.

But these are not flaws of the underlying science, they are flaws of application and translation. They are the kind of flaws found in peer-reviewed research in other social and behavioral sciences. If we use this period of soul-searching well, we will begin to recognize, teach, and remedy these and other deficiencies of translation.

I think Brooks is wrong. We will not blow up the field. We will improve it while remaining a science. There are plenty of economists who have been simultaneously scientists and moral philosophers (and maybe even artists) who will lead the way. Some of them have even won Nobel prizes. They just haven't gotten much attention until recently. The market for their ideas has been "depressed."

Let's hope recent events in housing and finance (and soon health, I'll bet) will change that.

Sometimes Business Isn't Just Business

I woke up this morning thinking about the guy from whom we used to buy firewood. The first time he delivered a load of wood, he volunteered the unusual idea that unisex bathrooms were a gay conspiracy to turn us all into homosexuals and that the government was helping "them" to do this.

I remember my husband and me discussing whether or not to continue a business relationship with him. It wasn't just that he seemed a bit of a loon, it was also the implied prejudice against gays. The prejudice against the government was so ubiquitous at the time and where we lived that we hardly noticed it.  "Should we give the guy our business?" we asked ourselves. "His ideas are so unusual and he seems to hold some values that are at odds with ours."

In the end, our decision to continue a business relationship with him was motivated by two things: 1) the wood was dry, good quality hardwood, delivered on time, at a reasonable price, and it fit our small fireplace and 2) we weren't buying political philosophy from him, we were buying firewood. What can I say? I'm an economist and a child of the merchant class. Business is business.

That's the beauty of the market. Two individuals with deep and abiding differences in worldview can find common cause in commercial exchange. For 10 years, we enjoyed dry, high quality hardwood delivered on time and at a very reasonable price compared to prevailing quality-adjusted market prices. Mind you, he wasn't ever going to be a viable candidate for "friend" or "suitable marriage partner for the nieces," but that's not what we were in the firewood market for.

There was an additional cost, however. Whichever one of us helped him unload and stack the wood had to listen to some very unusual ideas about the government. This was during the GW Bush administration. Frankly, he didn't like GWB any better than he liked the Clinton administration. It didn't seem to be left-right, so much as anti-guvmint. The fact that one political party's platform better aligned with some of his unusual ideas about gays and guvmint were what seemed to place him on the right.

The last time we bought firewood from him was right after Mr. Obama was elected president. The conversation that day was more alarming than others had been. Whatever his reservations about government, even that of GWB, they had somehow now become magnified. For the first time in 10 years of firewood deliveries, we heard racism creep into his "interesting" ideas.

My husband helped him unload wood that day. I remember when he came back into the house, he said, "You know, Maxine, it's good we're moving, because if we weren't, I think we'd have to find another firewood supplier. I think he's crossed the threshold from "unusual ideas" to "possibly dangerous."

That's the other beauty of markets with many competitors. If you really believe that someone with whom you have a commercial exchange relationship has ventured into ideological territory that undermines the ideas and institutions you hold dear, the very institutions that support that commercial exchange, or if you believe that same someone threatens the freedoms of all groups by threatening the freedoms of some groups, you can do business with someone else.

And so we would have, had we not moved away.

I'm not sure why I'm telling you this story. Maybe because it's a story about how people with very different ideas can be brought together peaceably by commercial exchange, a mere desire to truck and barter with each other, giving value and getting value. Its a story about how they can tolerate someone with ideas that are quite at odds with their own because the market has provided them with neutral ground where they can meet, exchange, and part, better off for the transaction.

But it's also a story about how, at some point, something other than gaining and getting may also matter. When one party to the exchange promotes ideas that could undermine the social fabric that makes the exchange possible, is it time to step back and ask ourselves: what are we trading and bartering here? If one party to the exchange promotes ideas that could undermine the institutions and tolerance and moral fabric that make markets and democracy possible, should we be more willing to take our business elsewhere, and sooner?

Unfortunately, it can work both ways. That is exactly how markets, and with them civil rights, were undermined in the deep South. Merchants who supported civil rights or who served blacks were boycotted or worse. The "markets" reflected the prevailing moral or immoral sentiments.

I don't want to live in a world where we choose who we do business with based on their politics or beliefs or who their customers are or aren't. That seems too much like choosing them based on race or religion or who they're related to. Business is business. I've always thought of it as the great leveler. If someone delivers a high-quality product at a competitive price with good customer service, that should be sufficient to gain my business.

But today I find myself thinking about the firewood guy. Maybe business isn't always just business.

An American Tragedy

When public discourse gets crazy, the crazies are usually paying attention.

My prayers are with Gabrielle Giffords, her family, the other victims and their families, and with our nation.

A Code of Ethics for Economists

Almost 300 economists, including yours truly in her IRL alter-ego, have signed a letter to American Economic Association President Robert Hall asking that the AEA adopt a code of ethics that requires "disclosure of potential conflicts of interest that can arise between economists’ roles as economic experts and as paid consultants, principals or agents for private firms." This article by Annie Lowry at Slate does a pretty good job of describing the underlying issues as well as both the ethics and economics of such conflicts of interest. You can read other accounts here, here, and here.

From the letter:

This issue has taken on greater salience as the recent financial crisis has highlighted economists’ potentially conflicting roles that may have affected their real or perceived impartiality as analysts and experts. For example, in an assessment of 19 economists who have played prominent and influential roles in recent public policy debates, Gerald Epstein and Jessica Carrick-Hagenbarth found that 13 out of 19 economists had private financial affiliations indicative of some possible conflicts of interest, but only 5 had clearly and publicly revealed their affiliations. A Reuters study of Congressional testimony by academics (many but not all of whom are economists) analyzed “… 96 testimonies given by 82 academics to the Senate Banking Committee and the House Financial Services Committee between late 2008 and early 2010 -- as lawmakers debated the biggest overhaul of financial regulation since the 1930s.” They found that “…roughly a third (of the academics) did not reveal their financial affiliations in their testimonies, based on a comparison of the text of their testimonies available on the Congressional committees’ websites with their resumes available online.”

Economics is unusual among the social science professions in that it lacks professional ethical codes or guidelines. In addition to the American Sociological Association, the American Anthropology Association has a code of ethics. Similarly, the American Psychology Association and the American Statistical Association both have guidelines for ethics. These codes and guidelines vary in several ways: some demand that professional members simply reveal potential conflicts; others demand that they do whatever they can to avoid or end such conflicts.

Gerald Epstein and Jessica Carrick-Hagenbarth, cited above, coordinated and led this effort to petition the AEA.

Reuters reports that AEA President Hall is skeptical of the effectiveness of an ethical code, believing that because the AEA has no power of enforcement, a code of ethics would have no real effect. This seems an unusual position from a member of a profession that has built much of its theory on the rational self-interest of fully-informed consumers.

I like to think the "market" works a little better than that.

If a professional organization has a code of ethics and someone violates it, then public revelation of that information should have the effect of imposing a reputational cost on that person even in the absence of formal sanction. The reputational cost derives from the existence of a professional standard that has been violated. At present, failure to declare a conflict of interest can be viewed as an oversight. With a professional standard, it becomes at least a putative duty and obligation to reveal one's COIs.

In order to make it a real duty and obligation, I suspect that adoption of a professional code of ethics is a necessary first step toward the day when revelation of conflict of interest becomes ingrained in our professional personae and roles, part of a fiduciary responsibility that has become second nature. As long as there is no professional standard, there is less likelihood that such ethical behavior will become the professional norm and it must become the norm if the standard is ever to have real meaning.

There may be other benefits to adoption of a professional code of ethics. It serves as a reminder that when we speak or advise, it has the potential to harm or help others. Sometimes millions of "others." We economists tend to be somewhat individualistic in our orientation; some of us solidly in the caveat emptor camp. I wonder if sometimes it blinds us to the potential harm our advice could inflict on (less knowledgable) others. As with other professions (perhaps more so than many), economists have the potential to impose real externalities for good or for ill on the rest of our countrymen (and women and children). This is why it is so important that our private objectives and incentives be transparent, especially when they might be at odds with the public's interest.

Finally, a code of ethics that requires transparency with regard to conflicts of interest must almost certainly be net beneficial to our professional "brand." As the letter to the AEA puts it:

In conclusion, we strongly urge that the AEA create and then promote adherence to a professional code of ethics that at a minimum requires transparency with respect to potential conflicts of interest. We believe this would be an important and necessary step toward enhancing the credibility and integrity of the profession.

In my very humble opinion, a professional code of ethics for economists is long overdue.

(I wonder if anyone will read this? They're all at the annual conference.)

Philanthrocapitalism or Paternalism in New Guise?

Some Economics Background

There are two concepts that are key to understanding how we economists view and interpret the world. One is consumer surplus (and it's production-side counterpart, producer surplus). The other is consumer sovereignty. I'm not saying that these are all there is to economic thought and theory, but if you want to understand what approximates the moral underpinnings of economics as currently practiced, these are the two I think you should start with.

First, consumer surplus. This is our welfare measure. We believe it captures how much better off you are made by competitive markets. "How so?" you ask. Well, batten down the hatches and I'll try to explain it.

Start with the idea that there are things that make you better off by some metric that you and you alone possess. If you have more of these things, you are happier, more satisfied, "better off" you might say. If you have less, you aren't as happy, satisfied, or well off. And you have only a certain amount of income with which to acquire that combination of goods and services that will make you happier, more satisfied, better off. You must go into the marketplace, with that income serving as a constraint, and choose the right mix and amounts of goods and services that make you as well off as you can possibly be (in your own estimation) without exceeding your income. (We're going to assume away borrowing in this discussion and we're going to ignore how you come by the income you take to market.)

Let's say that you have determined that what will make you best off today is the acquisition of six pieces of apple pie. Let's also assume for a moment that you have to buy them one at a time, negotiating a price for each slice that you acquire. Let's also assume that you are hungry and intend to eat the first piece of pie right away. That first piece provides a very high amount of happiness, satisfaction, and well-being. The amount you are willing to pay for it is also high, reflecting the amount of happiness, satisfaction, and well-being you expect to derive from consuming it. The second slice, yields a bit less happiness, satisfaction, etc. After all you already have one. For this reason, you negotiate a slightly lower price, one that reflects the lower benefit you expect to receive from it. The third piece is even less beneficial and so you are willing to pay even less for it. And so it goes until you reach the 6th piece of pie or the 3rd piece of pie or whichever piece it is that costs more than the benefit you expect to derive from it (the seller is bargaining, too, and there's some price below which he cannot sell you the slice of apple pie and still at least cover the cost of its production).

This yields the classically downward sloping individual demand curve seen in economics text books.

The beauty of the market is that you don't have to negotiate the price of each unit of a good you purchase. You arrive there to find that all slices of pie are sold at the same price. You were willing to pay more for slices 1, 2, and 3, but you find you can acquire them for the same price you were willing to pay for slice 4! The difference between what you were willing to pay for the 4 slices and what you actually pay is what we call consumer surplus. It measures how much better off you are made by a well-functioning competitive market that provides you all the pieces of pie at the price that equals the cost of producing the very last unit of pie. (Producer's surplus measures the gains to the producer who gets to sell all the units produced at a price that reflects the cost of the last unit produced, that is, it costs him less to produce the next to the last and even less to produce the next to the next to the last and....you get the idea...so he makes profit on all but the last unit produced.) Consumer surplus is denoted by the triangle bounded by $6, $2, and where the line from 4 units intersects the green demand curve in the diagram below.

If the market is competitive, the $2 price will be very close to the actual costs of producing pie slice #4. Market forces will foster competition among firms to produce pie slices at the lowest cost possible while maintaining quality. (Of course, if ingredients are not labeled, consumers may be hoodwinked on quality. If you doubt me, spend some time reading about why we had to have food regulation in the US.)

The larger is consumer surplus, the better off are we. Why? Well, one reason is that our total satisfaction exceeds the value of the money we had to part with to achieve it. Another is that because we didn't have to pay the amount we actually value each pie slice at, we retain that money to spend on other things that will also make us happier.

One of the best ways to make consumer surplus large is to live in a world where price is a low as it can be (subject to the constraint that the product actually delivers those qualities which the consumer values). Think "truth in advertising" and "consumer financial protection" and food and nutrition labels. A well-functioning competitive market with no information asymmetries, no agency problems, no monopolies, no externalities would (at least in theory) deliver this most utopian of results.

The other key concept that emerges from this simplified overview of welfare economics is consumer sovereignty. This is the "liberty" that is (as far as I can tell) the primary moral byproduct of a well-functioning free market. It means that we get to decide what makes us happiest, what is best for us. We vote with our dollars in markets, signalling that which we value most. It transmits to producers who, if they are alert and desire to make a profit, supply us with that which we desire in the right amounts and mix (subject to technology constraints). And we all live happily ever after. No standing in line at the store because central planners decided we needed more shoes while we wanted more bread. No empty shelves because someone in Washington guessed wrong about that which we desired. A perfect match between what we want and what we get, every time (of course, subject to that pesky budget constraint...but, hey, nothing's perfect).

More for less and you decide what you want more of. Not a bad system when it works (and it often does).

Sometimes Things Don't Work Out

More recently, it appears that consumer surplus has been eroded. In financing of mortgages and consumer credit, obviously. Maybe in computer operating systems, like Microsoft Windows. It happens when private incentives don't align social objectives (i.e., investment banker's private incentives to get rich are at odds with social objectives to allocate capital efficiently and effectively to promote innovation, production, and anything else that enhances societal well-being). It happens when there are information asymmetries, that is, when buyers don't know exactly what it is they are paying for (think, for example, health care and insurance, sub-prime mortgages, and used cars). And it happens when a company is large with a dominant market share.

The last is called monopoly. It allows the firm to chose the level of output it will produce rather than supplying all that it could at a prevailing (competitive) market price. The firm will choose the level of output at which profits are maximized. This has two negative effects on consumers: it reduces total output available for consumption and it raises the price they must pay for units that in a competitive market they would get for less. It has a very positive effect for the firm: it makes profits higher than they would be in a competitive market and at higher cost to consumers. The excess of profits over what they would be in a competitive market is called economic rents.

Erosion of consumer surplus is also why taxes are Bad Things. They raise price, thereby reducing consumer surplus (and producer surplus, depending on the relative price elasticities of demand and supply). But they are viewed by most economists as worse than the kinds of erosion of consumer surplus above, because they result in something called "dead weight loss." In the scenarios above, when consumer surplus is eroded, the part that consumers lose is transferred to producers, so there's no real loss in the total scheme of things. Just a transfer from consumers to producers or sellers. With taxes, there is a reduction in demand (due to the higher price) and in supply (due to the absence of demand), the dead weight loss.

Of course, the tax situation is portrayed in a two-dimensional world in which only a single good is demanded and supplied. If the revenues raised by the tax produce some public good, say cleaner air, purer food, better child health and nutrition, perhaps even a redistribution of income that results in higher levels of societal trust and lower crime rates (imagine things you might value over and above the monetary price (the tax revenues) of producing them) or if there is some externality of production, then some of that dead weight loss might just be offset. But that would require us to imagine that there are other components to well-being besides output and individual income.

Where We Seem to Be Heading

It appears that over the last 30 years wealth and political power have become more concentrated as has market power and its natural bedfellow, political power. Incomes have become more unequal with the spoils of market and political power going disproportionately to captains of finance and industry. If not corrected, some among us may begin to question the value of an economic system that has ceased to deliver universal opulence to worker, rentier and investor alike.

The answer to this from those who still value a capitalist system appears to be creation of a new class of philanthrocapitalists who, like Andrew Carnegie, after eroding consumer surplus and perhaps a soupçon of individual liberty (along with workers' wages (I didn't talk about this)) to gain higher profits, will turn around and redistribute that wealth in some way of their own choosing. That redistribution will presumably benefit us all, though we may have little say in it.

And I, a big fan of Carnegie-financed libraries and universities and foundations, am left to ask the question I have always asked even of those same libraries, universities and foundations. Would we all have been better off if Carnegie had simply paid his workers higher wages? Would we all have been better off if Carnegie had simply charged lower prices? These were the opportunity costs of those libraries, universities and foundations. Wouldn't it have been better to increase consumer surplus and consumer sovereignty (and consumer wages)? I mean, my tastes and preferences happen to coincide with Carnegie's, at least as far as libraries, hospitals, universities, and foundations go. But what if the people working for him would have preferred to buy their own books or educate their children their own way? Or even party hard and long? Why do a wealthy philanthropist's tastes and preferences trump those of the people they employ? Make no mistake here. We're talking paternalism by a group of elites, just as surely as when the guvmint does it.

But let's bring this into the present. Why have I had to endure a klugey operating system with lousy file and memory management for nigh onto thirty years? Why have I had to pay outrageous amounts for every version of said operating system and put up with trojans and viruses and worms that are only possible because one operating system has captured 75% of the market? The homogeneity of our computing infrastructure is probably the single greatest threat to national security. And for it, we all paid monopoly prices, the proceeds of which are now being spent at the discretion of Gates and his foundation. Am I better off because of his philanthropy than I would have been paying lower prices, retaining some consumer surplus, having more market choices? If some rich philanthropist, either alone or in concert with a non-profit or a government agency, is making decisions about how to spend the "extra" money he gained from me, how is that different from the government making decisions about how to spend the tax revenues it gains from me? Do not both usurp my economic power and autonomy?

One answer to the last question (I had the audacity to hope) is that the government is constituted to be of, by and for the people. The people. All the people. So there is some hope that tax revenues might be spent in ways that benefit us all.

But maybe there is no difference between how a democratically elected government will spend my taxes and how a philanthrocapitalist will spend the economic rents he extracts from me. In that case, higher wages, lower prices, and a less unequal income distribution (that is to say, lower profits) would better enhance the two key elements of consumer economic welfare: consumer surplus and consumer sovereignty. I wonder what wealthy philanthrocapitalist or public-private partnership will deliver these to us?

'Tis the Season...

I started blogging a little over a year ago. Last night over dinner, a friend asked me why I do it. The answers I gave him were: I love to write and I want to be part of the really exciting conversation about economics and economic thought that has been a byproduct of the financial sector's mismanagement of risk.

I didn't say it last night, but I think I also started blogging because I grew up in a family business and have become increasingly appalled over the last 10 years or so by what seems to me to be a very limited view of the duties, obligations, and responsibilities of business.

I remember the sense of incompleteness and confusion I felt when first exposed to the theory of the firm. You see, in our business we were not profit maximizers. We were business men and women, embedded in a community, our fate intertwined with that of the community. We had to make enough money to stay in business for the long-haul. That meant that our customers had to keep coming back, we had to provide value, and we had to work, to sell. No one who walked into our business was greeted with "Let me know if I can help you." The customer was like a sacred guest. Our job was to find out what she needed, to tell him as much as we could about the merits of our merchandise, to help them identify and purchase the best match for their preferences and their pocketbook, or to send them to a competitor, with directions on how to get there, if we didn't have and couldn't get what they were looking for.

Our long-term survival depended on some amount of profits, but equally important were reputation and civic responsibility. These three are what we optimized over, not profits alone. We viewed all of these as interdependent. That meant that sometimes reputation and civic obligation were a constraint on profits.

We were also a small firm. The kind of firm economists like to imagine populates the ideal of a competitive market. And so they do. And our market was local, better suited to enhancing our moral sentiments about and our ethical commitments to our customers. our employees, and our community than global markets are, perhaps.

Now, after a year of blogging, I'm discouraged and puzzled.

I can understand that someone who has managed to capture a privileged economic and political position, one where they are backed by US taxpayers as they gamble for personal gain in financial casinos, will do whatever they must to maintain it. And I expect that over time, if unchecked and unchastized, they will take on increasing amounts of risk, underwritten by the rest of us. What I didn't expect was the magnitude of the moral failure: that financiers would help to create securities designed to fail, sell them to clients, and then bet against them. 

What I can't understand is the willingness of the citizenry to protect and reward someone who has harmed or is continung to harm them. I do not understand voting for politicians who support tax cuts for and neutered regulation of these same destructive speculators. Nor do I understand voters' apparent willingness to eviscerate all of the social programs and safety nets that are all that stand between them and what can only be regarded as neo-feudalism. I conjecture that the reason for this counterintuitive behavior is that the moral narrative that accompanies a technocratic tax cut for the wealthy is more compelling that the moral narrative that accompanies a technocratic stimulus of aggregate demand or support for families harmed by the financial sector's market and moral failures.

If you had told me 10 years ago that I would become a critic of investment bankers and an advocate for labor, I would have said that you were crazy. I was weaned on horror stories about the New Deal, the WPA and CCC, wage and price controls, and the horror of unions. (And, if we ever return to a point where unions become so powerful that they impede business, I will blog against them.)

I grew up in relatively egalitarian (at the time) Appalachia. My family had more money than most. I had two best friends. One friend's father was a (union member) coal miner who died of black lung disease when he was in his sixties. The other's father pumped gas at the local gas station, while his wife baked the most delicious bread and sold it to her neighbors. There was a compression that occurred in coal-mining and steel-producing towns. I think it's something about the landscape and the drear tar-paper brick houses and the fact that we all lived so close to each other. It causes those at the top of the income distribution to want not to seem too far above. But it may also be that money just isn't that important when most people don't have much of it. It also helps that the most you can spend on a dinner out is $20 per person (with wine) because that is the most the best restaurant in town charges for the top-of-the-menu T-bone steak with two vegetables (where mac and cheese and jello are both considered vegetables) and a glass of the "house wine."

I remember thinking until I was about 8 years old, that my only job options would be five and dime store clerk or bookkeeper, because those were the jobs women seemed to hold in my town. Mercifully, I didn't have to become a store clerk (although I've worked as one and was darn good at it, too) or a bookkeeper, but I remember feeling despair at the prospect even as an 8 year old. Maybe that is why I care so much about educational opportunity for anyone, anyone, who wants it.

And I remember that nearly every strikingly beautiful mountain vista was marred by a gas well or a coal tipple or a boney pile. It was the price, I told myself, of progress and the American dream. They kept my friends' fathers employed and my family in business.

Now I find myself wondering if the price is becoming too high, paid by those who can least afford it, and collected disproportionately by those who no longer generate the jobs or the universal opulence that used to be justification for that disproportionate allocation. I'm also increasingly concerned about how that price is set and the one-sided and self-serving (for those at the top) discourse that surrounds it.

I got into this conversation because I felt I might be able to contribute clarity for those not trained in economics and a different perspective. It has been an exciting and stimulating conversation. I've thought and read more about macroeconomics than I ever did in grad school. I have developed a real fondness and respect for my readers and their very thoughtful comments and for my fellow economics, anthropology, sociology, and biology bloggers, especially Mark Thoma, without whom only five people would ever have read this blog.

Now I find myself in need a a break, partly because I feel so discouraged by recent political events and the apparent triumph of zombie economics; partly because I have a paper and a grant proposal that need my attention. Barring some major new development, I'm going to take some time between now and New Years to reflect on what I've learned this past year and on the conversation we have had. I'll be back online around the New Year. In the meantime, if you're in the mood for a more seasonal essay, you might want to read my winter solstice post on my other blog. It contains the words "GDP" and "incentives," but is more in the spirit of the holiday season than this blog has been.

Happy Holidays and Best Wishes for a prosperous, opulent, full-employment, non-volatile, no negative externalities New Year for us all!