Tuesday, November 20, 2007

The Wrong Probability

I saw a small sign put up by students in the stairwell today. I'd seen it before but ignored it. Today it caught my attention. It said simply:
39% of all Traffic Fatalities are alcohol related.
What is wrong with this probability? It does little to suggest that you should not drive while drunk. The fraction of alcohol-related fatalities might rise simply because overall accidents decline! What fraction of traffic fatalities should be alcohol related, anyway? Aren't traffic fatalities bad, regardless of the cause? We don't really care about the probability that an accident involves alcohol, given that the accident has occurred. What probability would be useful? We would need to know the probability that a driver has a traffic accident, given that he or she has been drinking. Even better would be a probability based on the amount of alcohol consumed. If the sign had said "39% of drivers who have had one more drinks prior to driving have a traffic accident," that would be a very sobering statistic.

Another example of this wrong probability is sometimes encountered when discussing hard drugs. I recall hearing numbers in high school such as "80% of cocaine users used marijuana prior to using cocaine" (I'm making the number up; I'm not sure what the actual cited number was, and it doesn't really matter for making my point). This number was intended to suggest that marijuana is a gateway drug--that if you use marijuana, you will likely go on to use cocaine. The problem is that it's the wrong probability. What we really need to know is the fraction of marijuana users who go on to use cocaine.

Monday, November 19, 2007

Puzzles

Two things that puzzle me:

1) Why do video games have humanoid aliens? I understand why humanoid aliens are so common in television and movies--it's much cheaper to slap some makeup on a person than to have a quadraped with two mouths and tentacles. But video games should allow the creators' minds to run wild. Instead, developers seem to stick to the standard, boring biped (for intelligent aliens, anyway). Take Mass Effect, for example. Every screenshot I've seen from the game features humanoids. Some are skinny, some are thick, but they've all got two legs, two arms, and a head atop their shoulders, with two eyes and a mouth. Boring! One of the things I used to love about the Star Frontiers pen-and-paper RPG was the diversity of the aliens. It had eight-legged insectoid vrusk, ameoba-like dralasites, four-legged two-tongued Osakar, and the worm-like Sathar. It also had a couple non-human humanoids (Yazirians and Ifshnit, although I think everyone decided to ignore the Ifshnit), and the Humma, who looked sort of like kangaroos.

2) Why do doctors ask you to rate pain on a scale of one to ten? Don't they know interpersonal utility comparisons are very difficult? I had a kidney stone several years ago. When it started to cause pain I didn't know exactly what was going on, so I went to the hospital. The pain got worse and worse, and the doctor asked me "On a scale of one to ten, with ten being the worst pain imaginable, how much does it hurt?" I started to answer "ten", but then I thought it might hurt more if I had a kidney stone and someone was trying to saw my arm off. And that wouldn't hurt as much as a kidney stone, my arm being sawn off, and a heavy weight crushing my foot. How can I possible rate my pain from one to ten? Furthemore, is this scale linear? Is it logarithmic? Is ten twice as painful as five, or is it ten times as painful as nine?

Friday, November 16, 2007

Where Do Prices and Wages Come From?

The following is an excerpt from my lecture notes on supply and demand. It starts with a quote from a former colleague in the Philosophy department, who proposed that employers control labor markets. I then present two alternative theories: workers or consumers control prices, and finally, Supply and Demand determine prices. Only the latter makes sense.

Where do prices and wages come from?

Theory One: Businesses choose them (because they have “power”)

I have read and heard the claim that the market produces equilibrium between employers and workers, and I find it unpersuasive. The need to earn a living in order to survive requires that the worker sell labor. Workers are thereby required to accept the employer’s right to command their behavior, and are typically excluded from participating in the decisions that determine their efforts. Certain rights, claimed to be inalienable, are forfeited or suspended, consigned to the control of others. This imbalance of ‘power’ can be observed early: in the process of getting a job. Standards of work and performance, even the time, place and duration of the job interview, are established by the employer. The employment system seems not very different from the feudal arrangement in which the noble owned the land and the serfs were subject to his rule.”

-A colleague in Philosophy

Theory Two: Workers/Consumers choose them (because they have “power”)

The need to sell products to survive requires that the employer purchase labor. Employers are thereby required to accept the employee’s right to choose the circumstances of their employment, and are typically excluded from participating in the decisions that determine the use of labor.”

Or:

The need to earn profit to survive requires that the firm sell goods and services. Firms are thereby required to accept the consumer’s right to choose the circumstances of their purchases, and are typically excluded from participating in the decisions that determine quality and price of goods produced.”

Theory Three: Marshallian Scissors

“We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.”

-Alfred Marshall

What is the point? The point is that statements like "employers set wages" or "consumers set prices" don't make sense. These are not real explanations of wages or prices, because they predict a world that does not exist. If employers really had complete control over wages, they would set wages of all employees such that they could barely survive. Clearly this is not the case, even for non-unionized employees. If employees set wages, they would set wages such that businesses could barely survive (or possibly lower, if there was a coordination failure). Clearly this is not the case. If consumers set prices of goods and services, they would set prices such that businesses could barely survive (or, again, possibly lower). Clearly this is not the case.

Alfred Marshall showed the solution: Arguing about whether consumers or producers (or employers or employees) determine prices is like arguing about whether the upper or lower blade of a pair of scissors cuts a piece of paper. It takes both blades to cut paper, and it takes both producers and consumers--Supply and Demand--to set prices (a wage being merely a price of labor). For this reason, Supply and Demand diagrams are sometimes called Marshallian Scissors.
The amazing thing is that in such a market, no one is in charge of setting the price. The price emerges as a result of the activities of tens or hundreds or thousands or even millions of people, with no central direction. Of course, this assumes that the market in question is competitive--there must be several buyers and several sellers. This is almost universally the case in labor markets, and mostly true in product markets, but there are exceptions.

EDIT: An alternate graph has been added for readers confused by the previous graph.

Wednesday, November 14, 2007

Blogs That I Enjoy

Here is a list of blogs that I enjoy reading, along with some comments:

Brad Delong's Semi-Daily Journal
This is a left-leaning blog written by an expert in economic history. His blog tends to have a macro bent to it, but I still somehow manage to enjoy it. Professor Delong is fair when reviewing the work of people with whom he has political disagreements, and he is always provocative and interesting. My only complaint is that he is excessively abrasive, resorting to name-calling. I'm sure he'd respond that it is deserved, and maybe it is, but I couldn't bring myself to have a "stupidest man alive" regular feature.

Cafe Hayek
Primarily written by Don Boudreaux and Russel Roberts, this is a general economics blog that tends to focus on criticizing mainstream economics from a free-market perspective. The educational posts, particularly on trade, are fantastic. The Econtalk podcasts by Russell Roberts are also fantastic. I sometimes think that the blog posts are a bit fuzzy, though. The authors are not anarchists, yet they always come down as opposed to government intervention; I would like to hear them explain what they think the proper role of government actually is. Do they support any environmental regulation, for example, or do they believe the political outcome will always be inefficient? The recent podcast with Bruce Yandle gave me the impression that Russell Roberts would never support any environmental regulation.

David Friedman's Ideas
David Friedman (the son of Milton Friedman) is an economist anarchist anachronist libertarian who has never taken a class in economics or law, yet teaches economics in a law school. There may be two libertarians somewhere who agree with each other, but David Friedman is not one of them (or so he says). His posts range from economics to biology to his what his preferred cell phone would be like. Recently he's been blogging about his efforts to help his daughter find a college. This is one of my favorite blogs, as it's always interesting, thoughtful, and fair.

Autoblog and Autoblog Green
These sites are good sources of the latest information on autmotive technology. I find technological innovation in cars fascinating.

The Undercover Economist by Tim Harford
This is another general economics blog by an economist known for his prose. He wrote a book by the same name which I highly recommend. He's one of the best economic communicators we have. Harford doesn't seem to have a particular political axe to grind, although like most economists, he leans more heavily toward markets than the average person.

Marginal Revolution

This is probably the top economics blog (in terms of traffic). Tyler Cowen and Alex Tabarrok comment on anything and everything, not all of it close to what most people consider economics. Personally I find much of Cowen's stuff a bit on the cutesy side, but it is still fun to read most of the time.

Hit & Run
This is Reason Magazine's award-winning blog. Various Reason authors contribute on all sorts of subjects. Sometimes the hyperbole gets to be a bit much (as should be expected from a libertarian blog from an avowedly libertarian magazine). Still, it's usually good for quite a few laughs and some thought-provoking links. I particularly like the Progressive Rock Youtube links on weekends (although I'm not really sure why they're there).

I also read Mankiw's blog on occasion, and this environmental economics blog, although I often find them to be dry.

Responses on Unions

I have a colleague who is fond of saying that "One cannot overcome the fact that coffee is a constant-cost industry with sheer force of will." He says this when discussing fair trade coffee, which is coffee produced by workers who are paid by people trying to raise the equilibrium price by paying more. The problem is that doing this lures more coffee producers into the market, pushing the market price back down, leading to more poor coffee producers (and possibly resulting in fewer sales by those who get the "fair trade" price, because people shift to buying the cheaper coffee). Of course, the real reason they are poor is not that they are being taken advantage of by evil foreigners; the reason they are poor is that they are less productive than workers in other countries (that is not to say they do not work hard--productivity has to do with how much output one gets for a given amount of labor, not with how hard the worker works). It's not clear that the fair trade coffee has really made a net positive contribution, but people vocally support it. I suspect that there are some of you who are, at this very moment, thinking that I must be evil for questioning it.

But again I say to you, "You cannot overcome the fact that coffee is a constant-cost industry with sheer force of will". You cannot, by wishing, keep new coffee makers from entering the industry, pushing the price back to the equilibrium price--the economics will not go away just because you don't understand it.

This brings me to my previous post. There were several responses to my post on unions, via email and other places. Frankly, most of them are worthless. Here's the problem: You don't know what you're talking about.

The rational thing to do would be not to talk about things one doesn't understand (or to read up on the subject if one is so inclined, although this is costly). I certainly avoid discussions of nuclear physics, because I'm pretty ignorant on the subject. The puzzling thing is when people freely discuss economics when they don't really know a damn thing about it. I know that lots of you are going to say "Economists don't know anything; they don't agree on anything it's not a real science." You're wrong, wrong, and wrong. Of course, it makes sense that you're wrong--you're ignorant on the subject. Why should you know that economists actually know a great deal about how people behave? Why should you know that economists agree on a great deal? Why should you know that, in economics, theories are tested with evidence, and bad theories are thrown out? Now if you're talking about Macroeconomics, then I'll grant you a bit more credit: Macroeconomics seems to be a field in which disagreement persists, and hypotheses have proven difficult to test with any degree of finality. Still, there are areas of agreement in Macro area, too (For example, we all agree that inflation is ultimately caused by increases in the money supply, and not by the oil crises or labor unions or any of the other factors that have been suggested in the past).

Let's start with the apparent inability to actually read what I wrote in my blog post. Many people seemed to take my post to mean "screw the poor". I actually explicitly said that if you're concerned about the poverty of low-income individuals, you should consider income redistribution, rather than unions. I don't know how you missed it. I never said that poverty doesn't exist. Nor did I suggest that poverty is good. I can't imagine how you inferred from my post that I don't believe poverty exists. I think that what you did--and it's common among people who are bad at separating their emotions from political arguments--is that when you decided that I was on the opposite side of a political argument from you, you decided that my intentions must be bad. That is, people on the other side are bad people, not just people who disagree because they are misinformed or because the science is not yet settled. Clearly, anyone who suggests unions could be harmful must be a bad person, and one should feel free to insult them (even if the insulter is not an expert, and the insulted is).

One person linked to this article. The problem with studies like this is that they generally do not include non-wage compensation, which now makes up quite a large portion of total compensation. If you read the details of this study, you'll find that they only looked at "Family Cash Income".
Family cash income does not include the value of non-cash compensation such as employer contributions to health insurance and retirement benefits, nor does it include the effect of taxes or non-cash benefits such as food stamps.
Consider this graph. It shows where the increase in total income for the average worker came from between 2000 and 2005. 35% of it came from health benefits alone. Only 29% of it was an actual increase in wages. You can argue--correctly--that low income workers are less likely to get these benefits, or that their benefits will be lower, but the question is, how much lower? You can't tell by looking at the Economic Mobility Project's report. We don't really know if middle- and lower-income blacks' total compensation has gone up or down if we don't include all forms of compensation.

The report used CPI-R-US to adjust for inflation. This is one of the better measures of inflation, as it tries to account for the quality improvements of goods purchased. There is evidence, however, that it still understates the improvement in the quality of goods, and therefore overstates inflation. That is, real wages have probably not fallen by as much as it appears, or have risen more than they appear. Add in non-monetary benefits, and the real picture could be radically different from what is presented in this report.

Also, this report really doesn't have anything to do with unions. How will unions increase income mobility among poor blacks? Most people don't work in unionized industries, and most union workers aren't poor blacks. Are you suggesting that we should unionize all workers, so that they can all get higher wages? Then you have a problem: If you raise the wages of all workers, then employers will hire fewer of them. This is the Law of Demand, and you cannot overcome it with sheer force of will. The workers most likely to be left out will be the lowest-skilled workers, and if racism is at work, it will also be the workers least-liked by those who control the union--possibly minority workers. Unions are good at providing above-market wages to workers who already have jobs. If you are worried about a low-income worker who has trouble getting a job at all, or a poor single mother who finds it difficult to fulfill her family obligations and hold a job, unionization will not help.

There's another problem with using this report as an argument for unions: Look at all those white workers who are better off than their parents. Most of them are not unionized. Why are their wages going up? It is almost certainly not any biological superiority. And they are, by and large, not being aided by unions. What is making the difference? Instead of simply saying "unionize them!" shouldn't you instead be asking "What is the cause of the difference?" I suspect that, if you look closely, you'll find an interesting answer. I don't know what it is, but if I had to guess, I would guess that it is the fact that blacks are more likely to live in urban areas, and that urban areas tend to have poorer schools, and that (for possibly racist reasons) blacks in urban areas get the worst schools of all. Poor education makes for a bleak future. So wouldn't it make more sense to improve the schools than to argue for unionization? Furthermore, unions in the U.S. traditionally have not been the friends of the very poor, women, and minorities (although they are, thankfully no longer explicitly racist or sexist).

Some of the other criticisms were along the lines of "Economists make unrealistic assumptions about humans". The reality is that all scientists make unrealistic assumptions. If a physicist wants to model billiard balls on a pool table, he might leave out friction on his first pass. That model will work so-so, but not great, so next he adds friction. Adding friction is good, but not perfect, so next he adds air resistance. Now the model predicts pretty well, but it's still not perfect. Should he stop there? Probably so. Adding more complexity to a model is not always worthwhile. The physicist knows that other factors (chaos theory, maybe) might make the model even more accurate, but the model would become unwieldy, and the simpler model predicts very, very well.

Similarly, economists know that people are not purely rational calculating machines. We know that markets are not always perfectly efficient (there's a huge literature on market failure, the highlights of which are taught in every Econ 101 class). It is a fact, however, that assuming rational self-interest results in pretty good predictions most of the time. It is also a fact that policies designed under the assumption that people are not rationally self-interested tend to turn out badly. It is possible that labor markets may not be exactly like the perfectly competitive model, but it is also true that they are far away from monopsony. The competitive model predicts better, and is the better model to use.

It is also true that most of you will go on being ignorant on the subject, because it is rational for you to do so. Bryan Caplan argues that it can be rational for you to hold incorrect beliefs, because there is no consequence for being wrong, and holding a belief can make you feel good. For example, it might feel good to believe that businesses are part of a conspiracy to oppress workers, and that only unions can counter them. It is wrong, but why should you bother to have a different view? Holding a more nuanced view (that labor unions are sometimes valuable, and sometimes not, and that worker exploitation is not likely to happen in competitive labor markets) would require costly study on your part. It might also make you less liked by your friends, or cause you to feel guilty for giving up your support for the little guy. (As it happens, I support the little guy too, but I don't think unions are the way to help him).

Incidentally, the "rationally irrational voter" argument applies to areas outside of economics. Creationists come up with bizarre arguments to support their religious view, and many people decide to believe them, rather than genuine scientists. Or, to take a less controversial example, people have strange views on toxicology. Surveys show that people say they are willing to pay large amounts to avoid very small risks. Bryan Caplan cites a survey of the general public and toxicologists, asking them to agree or disagree with the following statement:
For pesticides, it's not how much of the chemical you are exposed to that should worry you, but whether or not you are exposed at all.
Toxicologists know that it's the dose that makes the poison, so 94.6% either strongly disagree or disagree. Among the general public, however, 36.1% agree with the statement! Only 11.9% strongly disagree, and 47.3% disagree. We should therefore expect the public to overreact to toxic threats, because so many of them believe that even a tiny dose is dangerous.

To quote Murray Rothbard (an economist with whom I seldom agree):
"It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a 'dismal science.' But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance."

Sunday, November 11, 2007

Unions, Strikes, Power, and Wages

Let me start out this post by saying that I am in favor of the right of unions to organize, although I am not in favor of any special government protection of unions, including the prohibition of "yellow dog contracts". Unions can serve an important role in communicating information from low-tier workers to upper management. They may have lower transactions costs of coordinating certain kinds of worker activity than other forms of organization in some industries. If left to the competitive marketplace, we would only expect unions to survive in those areas where they are socially beneficial (again, absent any special protections).

Having said that, I would like to criticize a frequent justification for unions. It is often said that without unions, workers would be underpaid because they would have no bargaining power. If labor markets are competitive (that is, if there are several employers and several employees) then this is simply false. There is a reason why different people in different occupations earn different wages, and it has little to do with "power", and everything to do with Supply and Demand. IT workers are paid very well, until the supply of IT workers increases significantly, driving their wages down. Workers who work in oil extraction in the U.S. are paid one wage, but workers who work on oil platforms at sea for months at a time are paid a different, higher wage, because there are fewer workers willing to accept those conditions, driving supply down, and wages up.

In the absence of a labor union, workers in the automotive industry, writers in Hollywood, and truck drivers around the country would be paid the market wage. The market wage is the wage that sets the value to society of hiring one more worker equal to the cost to society of switching that worker away from doing something else. It is the efficient wage, and by that economists mean that it is the wage that maximizes the difference between benefits and costs to society. If the supply of workers is restricted somehow, driving the wage up, that does benefit those in the industry who keep their jobs, but it hurts those who are no longer employable at the higher wage. It also harms consumers of the product they are producing, because consumers must pay more in the form of higher prices and reduced output.

The writers in Hollywood are not facing a monopsony (a monopsony is a single buyer, whereas monopoly is a single seller). If they were facing a monopsony, they might indeed face exploitation as the single employer would pay less than the wage provided by a competitive market. But again, writers are not facing a monopsony. There are many companies hiring writers, not only in Hollywood, but around the country. Writers also have alternative employers, such as magazine publishers (when they write magazine articles) and the consumers themselves (when they write books). The fact that not everyone who wants to make a living being a writer can do so is not a market failure. Rather, it is an indication that some people should not be writers. The ultimate protection for workers is the choice of different employers. If no employers are willing to hire a worker for a wage the worker will accept for a job the worker wants, then the worker should consider a different line of work. Furthermore, an employer which consistently underpays its employees relative to its competitors will find that its competitors are quite willing to hire away the best workers. Employers do not pay the market wage because they like workers; they pay the market wage because the market leaves them little choice. If you don't believe this, then consider yourself in the role of buyer: When you walk into a store, can you dictate any price for goods you buy, regardless of market conditions? Of course not; the seller of goods will not sell to you if you are not willing to pay enough to justify his production. You cannot exploit the seller of goods if there are other buyers of goods, and the seller cannot exploit you if he faces competitors. The same argument applies to buying and selling labor as surely as it applies to goods and services.

The "power" paradigm of wages is bankrupt. It has no explanatory power. Do finance professors get paid more than economics professors because they have more "power"? Of course not. The reason is that finance professors are more useful outside of academia than economics professors; the demand for their services is greater. Schools must pay them more to lure them to the academy, and away from other opportunities. This is Supply and Demand. If you want to equate "greater demand" with "power", then I suppose you could do so, but I think that is an abuse of language. To say that the result of the uncoordinated, decentralized decisions of thousands of employees and employers is some kind of power struggle is bizarre.

Perhaps you feel that, even at a market wage, writers are underpaid. If so, rather than arguing in favor of a non-competitive labor market, won't you consider arguing in favor of income redistribution instead? If your concern is that workers are too poor, income transfers are probably a less costly way to achieve your goal than a labor cartel.

I've seen it argued that labor unions are simply the result of the free association of individuals, and should not be prohibited. I agree, but I wonder if those who put forward this argument would be willing to apply their logic consistently--say, in the case of product cartels. A group of business leaders who voluntarily agree to impose higher prices on consumers are doing the same thing as a group of workers who voluntarily agree to impose higher wages on employers (and again, the end result will likely be higher prices for consumers). As it happens, cartels usually fall apart because it is hard for each firm to stick to the agreement, and the same might be true of some unions, absent government policies to protect them. Collusion is collusion. If you're going to stand up for collusion in the name of free association, at least be consistent about it.

One last point: It is frequently argued that labor unions were once necessary, but they are no longer necessary. If you look at the data on wage growth in the U.S., you see quite clearly that wages grew quite rapidly before unions rose to power, and this wage growth continued after they came to power. There may have been a few circumstances of monopsony in which workers were taken advantage of, and in which unions were genuinely socially productive. I think that in general, however, the social contributions of unions throughout history have been oversold. That is, labor unions may never have been necessary, at least in most circumstances. We should not make the mistake of believing that just because something did happen, it is what should have happened.