Topic: Economics
The Economics of Random Stuff: Preferences Why preferences are just as important as incentives.by Jeff Peters
(conservative)
Monday, February 2, 2009
In the first article of the series, The Economics of Random Stuff, I give the basics of consumer preferences. In the neoclassical world, from which I reside, we think of preferences in the form of utility functions that represent the relative importance of the various goods and bads that we consume.
However, this financial crisis cries out for a bit more detail. Why should I dive into this discussion again? Economists recently have been paying significant attention to programs involving stimulus packages and bailouts. The central concern here is that economists are constantly seeking ways to distort incentives to get people to do things differently. They offer a stimulus package with hopes that it produces an income or wealth effect on society. The more money people have the more they will consume.
We can look at this from an inter-temporal point of view. An economist will propose a tax cut for perhaps two reasons: one to create a wealth effect today but also to create a wealth effect for tomorrow. If this happens, consumers will "smooth" their inter-temporal consumption and perhaps spend some more money today and some more money tomorrow (or whatever the time frame may be). This implies that people putting their tax cuts in their bank accounts don't matter because it will have some impact.
The economists who dislike the stimulus package argue from the point of view that there are no real wealth effects from government spending or deficit-financed tax cuts. That's because they see things as an alteration in prices rather than income. In other words, the an increase in government spending will cause the cost of living to rise in the future, therefore the consumer's perceived general price level will increase. Thus, if they were given a tax cut they will still consume less today and tomorrow to substitute for the future price increase from repaying debts. Thus, they see a substitution effect taking place, not a wealth effect. This is still another common incentive argument.
But an economist who pays attention to all of the fundamentals will always see something from the bottom up. Firstly, look at the resource constraint imposed on preferences (illustrating the fact that we can only consume what we can afford) and then the effects of wealth or price changes on consumption (income and substitution effects). The folks who are paying attention to the incentive arguments are only paying attention to what happens to changes in prices and income on consumption - thus they have a top-down approach. It's about time they seek to understand preferences before they try to understand the wealth and substitution effects.
Why? The preferences, or the relative important of one good or bad to another, will determine the elasticity of response to changes in prices and wealth. From my newly acquired point of view, let's put a huge halt on talking about whether the stimulus packages are good or bad, and place more emphasis on what consumers and suppliers prefer today and tomorrow.
Some important questions to ask are how do preferences change in the midst of a financial crisis? In relation to preferences, how do consumers and producers alter their intuitive estimations of the probabilities of success and failure during a recession era? Now we ask about the incentives: what does a subsidy mean for consumption today and tomorrow?
In wide spread economic disaster, it's very likely that people prefer to place more importance on tomorrow than today. It's also likely that they will prefer to know the amount of money they have as opposed to an amount they "hope" to have. This is the same as saying that probabilities for failure have increased and probabilities for success have decreased. This implies people will put less of their money into risky investments - unless they are insured a hell of a lot of money. The point being: folks in these days prefer to have their money then gamble it away.
The implications are huge. If people aren't smoothing their inter-temporal consumption patterns in a way that will cause more spending today, then subsidies for short term effects won't work. If people are given tax cuts and that money makes it's way to financial intermediaries, given the new preference of being more risk averse than before, or the new expected probabilities of failure, the inelastic response to an increase in savings (which means a small decrease in the interest rate in the loan market) suggests this subsidy will do very little to nothing even on the investment side. Thus, to get an adequate response out of inelastic behavior, the government may have to pump tons and tons of money into circulation in a very short period of time - something not likely to balance benefits and costs.
Why do most economists ignore preferences: because in mainstream economics we are taught to assume preferences are stable, the idea that preferences don't change. I am to some degree endorsing the point of view that preferences do radically change but only in response to severe situations like the one we are currently in. Although the stable preference assumption may work for modeling most instances, I think it's a relative mistake to make this assumption in these times.
I may be wrong in my analysis, but economists must start paying attention to all aspects of human behavioral models: the preference side and the resource (or relative price constraint) side.
In conclusion, incentives are important but so are preferences and how they change with experience in the world. If we want to talk about incentiving the world, first we need to talk about how easily people will respond to these income or price changes.
Interesting Ideas:
Most economists are not of the Austrian School which explains the mainstream neglect of changes in preferences.
Rebuttal:
Actually, this isn't a rebuttal but a clarification. Mises, I believe (due to a lack of education in the Austrian School), argued that there is no degree of stability in preferences - therefore making the case that suppliers would rather make a trade with a person today than tomorrow for fear that the consumer would change his or her mind. I think this is one fringe side of the perspective where the neoclassical microeconomists reside on the other. I believe it's sort of mix between the two, where there are certain conditions, such as costly crises, that significantly alter preferences. But yes, Austrians take preferences way more seriously than the Neoclassicals!
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Posted By: Jahfre Fire Eater
Date: 2009-02-02 19:46:57
Hi Christopher,
I'll offer my two cents on your question, why do most economists ignore preferences.
First, I'll address the word, "most". This is because most economists are:
1. Not adherents of the Austrian School and the business cycle.
2. Lifetime members of an academic/government guild (cult?) dedicated to supporting the aims of the government in a bifurcated guild apprenticeship program. One track produces progressive (Keynesian) economists and the other produces statist (Freidmanite) economists. Both flavors of government economists are champions of a growing empire. (house of cards)
3. They defend the cycle of government largesse that funds their deeply rooted, ancient guild.
These common characteristics are way more than preference :-) They are a way of life as much as any religious activity is.
So, that is why "most" is an appropriate observation.
Posted By: Walt Thiessen
Date: 2009-02-02 19:49:08
One of the things that continues to amaze and appall me about the way most modern economists look at the current crisis, apart from the fact that most completely ignore the real causes of the crisis (the Fed), is that almost none seem to think that it's important for people to save and recover their own financial situations before they start "consuming" again.
The fact is that the enormous diet of credit that America has been living on lays waste to the finances of individuals and families. This means they need to recover. They need to spend less and save more. In many cases, they need to spend less simply because they have less (sometimes substantially less) income.
I have long believed that the paramount aim of monetary policy advocates was to make people absorb as much debt as possible, in the vain belief that it would make the country richer. The current crisis reinforces my belief. Yet even I am amazed at the apparent blindness of those same advocates. They seem to believe that the elasticity of individuals is virtually unlimited and that excessive elasticity is not a serious factor in the equation. Anyone who has ever dealt with a broken elastic on a piece of clothing knows how silly it is to ignore elastic limits. Why can't economists understand it too?
This paradigm shows us most clearly, to those willing to see, just how unsustainable fiat money is, because a fiat money supply is so heavily dependent upon a country going deeper into debt in order to generate the pseudo-prosperity that such a system creates. It is a system heavily biased toward increasing debt levels of individuals in the process. Fiat money advocates cannot fathom the idea that a system dependent upon going deeper into debt in order to recover is a self-defeating system, and that fact is incredible.
I agree Walt, except that i believe "the aim of monetary policy was to make people absorb as much debt" not to make the country richer but to further enrich those who would benefit most. they have to know excessive personal debt does not make the country richer but can enrich an elite group.
if you look at the history of personal finance, in the fifties and sixties the man went to work forty hours and did well for his family, then about the early seventies the woman went to work also and the family did ok, then they both began working 50 hour weeks, then personal debt was gradually increased beginning in the eighties to the ridiculous levels now. the family is doing okay but two people work long hours and they are very leveraged. those funds and that extra productivity have gone somewhere. someone has benefitted from the many more hours of labor and the debt creation and it is not the american worker. So what is the next well they can draw from?
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