Behavioral Economics for Firms

On Friday I read this piece by Karl Smith on Apple and this piece by Matt Yglesias on Barnes and Noble.  I was struck by how both of these examples showed firms actually in the best interest of the executive (who get perks from working at the firm) and not the shareholders (who want to maximize return on investment).

I wonder if there is a limit to how well firms adhere to economic models>  We already have decent evidence that people don't necessarily respond rationally (or else why would they buy Apple shares?).  But the executives in the company create a principal agent problem, which may also cause issues at the level of the company itself.

This is not to knock economic models.  Epidemiology has many of the same limitations and we have to rely on some pretty challenging assumptions.  Rather it is to be careful, with any model, to recall the limitations and exceptions inherent in modeling a complex process.

When a model simply doesn't match reality

Karl Smith relates a story from Megan McArdle:

A woman called me out of the blue last week and told me her self-sufficiency counselor had suggested she get in touch with me. She had moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn't make ends meet any more. I told her I didn't know what I could do for her, but agreed to meet with her. She showed me all her pay stubs etc. She really did come out behind by several hundred dollars a month. She lost free health insurance and instead had to pay $230 a month for her employer-provided health insurance. Her rent associated with her section 8 voucher went up by 30% of the income gain (which is the rule). She lost the ($280 a month) subsidized child care voucher she had for after-school care for her child. She lost around $1600 a year of the EITC. She paid payroll tax on the additional income. Finally, the new job was in Boston, and she lived in a suburb. So now she has $300 a month of additional gas and parking charges. She asked me if she should go back to earning $25,000. I told her that she should first try to find a $35k job closer to home. Also, she apparently can't fully reverse her decision to take the higher paying job because she can't get the child care voucher back (the waiting list is several years long she thinks). She is really stuck. She tried taking an additional weekend job, but the combination of losing 30 percent in increased rent and paying for someone to take care of her child meant it didn't help much either.

Ms, McArdle tries to make a supply side argument here, where she points out that we are failing to create policies to incentive work among the poor (who can suffer a marginal tax rate of > 100% in many circumstances). It is a really interesting question why we focus on the top marginal tax rate and not the marginal tax rate for people in lower income brackets (where there is less of a competition effect). However, Karl Smith notices the really interesting behavioral issue here:

She faced a marginal tax rate in excess of 100%. This meant as her earned income went up she got poorer. What did she do? She tried to earn even more income. It was only we she failed at the attempt to make ends meet by supplying ever more labor to the free market that she try to go back to making less money.

So, not only do we have evidence from Matt Yglesias and Felix Salmon that top income earners don't necessarily even know their marginal rate, but we see low income people (facing a > 100% marginal rate of taxes) desperately trying to get more income and not less. It is not the case that the woman in this heartbreaking story decides that she would prefer to spend more time in leisure (so we can't intice her into working more). It is that working actually costs her money.

And her response is to get a second job!

Is it really too late to put supply side economics into the "special circumstances only" bin and leave it there? It may influence the odd movie producer, consultant, or freelancer (who have the ability to take on work in discrete projects and who have income sufficiency already). But this conceptual model seems to be absolutely dreadful at making predictions about how real people will act in most employment situations.

Apple Stock

Karl Smith is bearish on Apple:

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

This is really one of the paradoxes of the stock market. It is not clear whether or not companies that do not issue dividends will ever be investments that pay off. The longer Apple puts its cash in executive compensation without rewarding owners, the higher the risk that Karl Smith is right.

How many rich families do you know that sustained multi-generational wealth via the stock market? How many do it with real assets? It is worth thinking about.

Contradictions

Karl Smith is striking me as an optimist:

In any case, during the GOP Google debate there was a poll that asked GOP voters if someone should be denied medical treatment because they could not afford it. 80% said no. This is the end of the major question in my mind. If you answer no then you have de facto signed on to socialized medicine through some means.

After all, he is demanding consistency here. I am not sure that humans are especially good at consistency. People often get quite annoyed at me when I drive the speed limit. I have the attitude that if we all want to drive faster on the road I am game, but I am unwilling to get a speeding ticket because local government cannot reach consensus on an appropriate speed limit.

In the same vein, I suspect that there can be a lot of daylight between the principle here and the application. That being said, I'd be delighted if we did adopt a more socialized medical system, purely for reasons of economic efficiency.

The danger of deserve

Karl Smith:

On Facebook I think Robin framed the question as “how weak do temptations have to be before they make people less deserving of charity”

My clear answer would be that there is no level so low. Human suffering is bad. Reductions in human suffering are good.

Why humans are suffering is of concern to us in knowing when our interventions might be productive but it doesn’t affect whether they are warranted.

This is, in my view, precisely correct. The decision to impose a moral worthiness component to helping others is the source of a great deal of misery. For example, the moral implications of being HIV+ (in the early years of the epidemic) clearly reduced overall public health (due to stigma preventing patients from seeking care).

That isn't to say that some approaches that feel good may be counterproductive. If we are going to be good utilitarians then we really need to consider the global consequences of an action. Making one person better off at the cost of making many others miserable is typically a bad trade-off.

But, insofar as we can make lives better, does it ever make sense to ask if people deserve to have better lives?

Principal agents

I suspect that this reaction to a press release by the CEO of Netflix is just a principal agent problem:

In classical economics AOL should have died. Borders should have died.They should have spun every dime out to the shareholders who could have invested in the next big thing themselves.

However, Hastings is specifically saying this is the mark of a bad CEO and everyone nods there heads. He is saying that we should burn shareholder profits in an effort to move away from what made the company great.

Shareholders are diluted across thousands of mutual funds and cannot easily exercise control. Returning money to these people also means no longer being the CEO of Borders or AOL. Management loses access to resources and are looking for jobs with less experience. If there was a cultural sense in which winding down the firm made an executive more employable at a later firm, that would be different.

But, as it is, why would an executive ever decide to walk away from the resources of managing a large company when they could profit from spending down the corporate resources. It is not like they can be held accountable by the shareholders, in any meaningful sense. They merely need to promise that, in their judgement, they can invest the money more effectively than the shareholders and keep going.

Heck, how many people working for a large firm consider themselves as working for a shareholder pool as opposed to working for the CEO? After all, only one of these two groups has any day to day authority in the company and access to complete information.

Personal Finance talk

There has been a lot of discussion of personal finances in the blogsphere this weekend, and several really good points have been made. I want to comment on the cool stuff at Worthwhile Canadian Initiative, but first let us consider two interesting posts by Karl Smith. One is on Apple:

Let’s add up how much of the iMac, iPod, iPhone, iBook and iPad profts have been paid out to the owners of Apple. Well lets think. . . oh yes I have it now, ZERO DOLLARS! Not one single penny.

So far is this really different from what Allen Stanford did? I hear some of his investors actually got redemptions. But, I am sure Apple investors will get their money some day, right.

They have the value of their share of the company, but that might very well be spent on other things before any dividends are paid. It's scary to consider.

Even worse is his discussion of Sir Alan Sanford:

You can do whatever you want to Allen Stanford. He is now broke. He got beat up in prison. He may very well spend the rest of his life there. But, he’s 61 years old now. These experience were his life. You can’t take that away.

Once you realize that, you realize the fundamental vulnerability that everyone has in handing over your assets to someone else. There is just no recourse against the other person consuming them.

You have to trust and that’s at the heart of what call The Big Externality.

That is a lot more scary. It really makes the idea of a government sponsored pension program way more appealing. And it definitely makes one skeptical about the ability of a typical investor to manage their assets. After all, I would not have seen Apple as an atypical investment vehicle, mostly because I like and consume their products. But if they are not paying dividends, then the idea behind getting money out of them is entirely to sell shares to somebody else.

But why would they want to buy them if they do not produce returns?

Medical Free Markets

This is a very interesting post by Karl Smith:

Lack of jobs is why everyone feels bad, not because they have less or are poorer or the country isn’t producing or consuming as much. And, not to get to meta – in what I hope is an easily readable post – but an economy that makes lots of people feel bad is by definition a bad economy.

Moreover, the feeling that you have now about the economy is not the feeling of lack of value creation. Its not the feeling of socialism.

I wish I had more time to go into this because “what socialism feels like” is an important concept. However, my more conservative readers will may readily get the following example.

Have you ever been pissed off at the fact that your neighborhood school doesn’t teach any of the stuff you want and it feels like your kid is just wasting her valuable time going to all of these pointless classes for no reason. THAT, is what socialism feels like. That is what the lack of value creation feels like.

Its not that you are afraid of losing what you have or that budget constraints are pinching. Its that the stuff which is available to you sucks. It – in extreme cases – is a world where everyone has a job but where no grocery store has fresh milk. It’s a world where everyone gets a pay check but no one can find shoes that fit.

That is what socialism feels like. That is what government getting in the way of the market feels like. In many ways it’s the exact opposite of the way this feels.

Because you know I can’t resist: When you are waiting in your doctor’s office and she is 50mins late and proceeds to be rude to you and not give you “permission” to go buy the drug that you are dying to buy because its finally been “approved.” That’s what socialism feels like.

It is an important insight that much of the current crisis is not caused by excessive government intervention. Now, it could be true that we could get to a bad place with the addition of excessive government oversight, but I think it is fair to accept that we are not there yet.

That being said, I think the argument about seeing medical doctors (and how familiar this experience is in the US) should give us pause when we argue that the current medical system is free market. It isn't. It's also one of our few areas of growth (which Tyler Cowen sees as rent seeking areas absorbing the unemployed) which is also worth thinking about.

I wonder if we are asking the right questions about the long term?

Tax Policy

Mark has been discussing the concerns about the hardship that tax increases would inflict on those with an income exceeding $250,000 per year. In part I think that this line of discussion began with Greg Mankiw trying to use himself as an example of a person who might do less labor if the marginal tax rate increased. There were a number of great points brought up as to why this example had issues: see here, here, and here.

There was a second economics professor who also made similar claims although I found them a bit harder to evaluate as the example was not as clear. This argument seemed to be more about how hard this person would find it to make cutbacks rather than a specific example of how he would become less productive.

Yesterday,Noahpinion linked to a great article by Karl Smith that went to the heart of this discussion. The argument was whether tax increases (at the sort of marginal rates we currently have) really depress productivity. Karl Smith made a number of arguments that were worth considering, including:

Third, high income people don’t seem to be working that much more than low income people despite the fact that a natural propensity towards work can make one high income.

Indeed, the data show us that low income folks used to work a little more, but now they work a little less than high income folks. Yet, if the income and substitution effects were balanced for each person we would still expect higher income people to work more.

That’s because working hard can lead to more education, more experience and more promotions. Being hard working is also associated with having a conscientious personality type which is itself more valuable.

So if someone was simply born with a stronger propensity to work, we would expect that person to earn more income per hour. Thus we when look at the data we should see that all these high income people are working lots of hours.

Yet, we actually don’t see that. We see only a mild effect and even then that effect is not robust over time. Sometimes, high income folks are working less.

But the piece is a must read in the entirety. The key argument here, though, is whether the extremely small tax increases that are under discussion (a raise in the marginal tax rate for the highest income bracket from 36% to 39.6%) is really likely to make high income Americans less productive. Because if these tax increases don't disincent work and we accept that government finances really are a mess then the tax hikes seem to be a logical way to "share the cost of these increases".

But I also think that these points don't necessarily go far enough. Are we really convinced that a small decrease in productivity among the wealthy will be that devastating? What is the source of productivity in the American economy? Is it highly paid CEOs, hedge fund managers, lawyers and medical doctors, or is it the majority of workers who drive productivity?

I think it is essential to get this correct. A top down model of an economy (where the people at the top make the key decisions and are responsible for the output) did poorly in Soviet Russia. A bottom up theory of economic gains seems to make a lot more sense and that suggests that small productivity losses among the wealthy are not a serious concern.

It is worth emphasizing that, at this time, I am aware of two proposals to increase the tax rates of the wealthy: increasing the amount of wages on which FICA can be charged and returning to Clinton-era tax rates. Neither of these increases is a vast change in the marginal tax rate of this group. Clearly there are tax increases that would cause issues, but we can handle those when they show up and not now when all of the possible rates under discussion are sane.

The last example that people tend to bring up is innovation and how important it is to reward innovators. Now, as part of a first principle I would like to point out that the innovator is not always the person who profits the most from an invention (consider Nikola Tesla). But it is also worth noting, as Mark points out, that copyright law already provides enormous rewards for intellectual property holders.

So I think we should look to balance harms. Recent events have included layoffs of government workers into a economy with an extremely high unemployment rate. Are we sure that the consequences of a large body of long term unemployed workers will be better than that of small increases in tax rates?