Efficiency vs equality (part II)

In the previous post, I discussed “efficiency” without defining it. Economists have a very strict definition of this important term: if a state of the world can make some better off, without hurting anyone, that state of the world is more “efficient.” On the other hand, a new state of the world, that increases the overall size of the pie but makes some better off and others worse off is not “efficient” by this definition. One reason why economists use the stricter definition of efficiency is that under diminishing marginal utility, overall social welfare may not necessarily increase in the second case. However, in the first case, social welfare is always higher.

Economists have spent considerable time arguing that international trade is efficient. (As a caveat, Stiglitz and others have demonstrated instances where international trade can be inefficient but that is a discussion for another day). So in theory that means international trade makes some people better off and no one worse off. But at the same time, economists acknowledge that international trade leads to “winners” and “losers.” But there are no “losers” in a more efficient state of the world. How to square this circle? Economists argue that there can be a transfer of monies from the “winners” to the “losers” such that the “winners” are still better off and the “losers” are no worse off than before. Hence, as the example of international trade shows, efficiency and redistribution are not mutually exclusive. In fact, redistribution is absolutely necessary for international trade to be efficient!

Economists who believe in the efficiency of international trade (including myself) should also believe in increasing re-distribution from the “winners” to the “losers”. However, the tax code in the US has become increasingly regressive at the same time that globalization has increased dramatically. This is not efficient by economists own definition of efficiency. (Side note: are there situations under the theory of second best where increasingly regressive taxes contemporaneous with international trade can be efficient?).

In order to make international trade efficient, we need to better understand the “winners” and “losers.” The recent trade literature has luckily ignored Lucas’s advice and spent considerable effort trying to understand who is hurt from international trade. Hopefully this research will move us towards making international trade more efficient, but in the meantime, I am curious why economists have been silent as the US tax code has become more regressive over the years while loudly touting more free trade.

Efficiency vs equality (part I)

Inequality is the topic du jour in the United States and surprisingly even in economics. Surprising, because in my time in academia, it was definitely rarely a topic of research in the field. For example, out of the 100 or so PhD job market papers (which is a good proxy for where economic research is heading) I was aware of between 2008-2011, I dont think a single one was about inequality. Further, only a few academics were publishing papers in top journals on the subject of inequality. Robert Lucas, a nobel prize winner, and undoubtedly speaking for many economists, said in 2004, “one of the tendencies of sound economics, the most seductive, and in my opinion the most poisonous is to focus on questions of distribution.” 

Implicit in this statement, Lucas is assuming that there is always a trade-off between efficiency and equality and that thinking about increasing equality (or lowering inequality) must necessarily lead to less efficiency and is therefore “poisonous.” However, this is wrong for a few reasons. First, the second fundamental welfare theorem in economics posits that there is a very important instance where there is no trade-off between equality and efficiency. There are numerous other economic policy instances where there is no trade-off between efficiency and equality. Second, I would contend that even Lucas would agree that there is likely a certain level of inequality that would lead to sub-optimal economic efficiency. Where that point is, is very hard to say but without scholarship, how would Lucas imagine we could eventually have insights on this. I think that Lucas, and others like him, are perpetually stuck in the Cold War era, where thinking about issues of inequality meant “communism.” While there is no doubt that “communism” was a failure, economists and other scholars do a dis-service by not better understanding inequality. Forever drudging up the specter of communism as if that were the only alternative to an “efficient” model is intellectually dishonest. So with that opening salvo, more of my opinions on efficiency vs equality, inequality to come. 

Here's looking at you kid

Beautiful image in the Sky over Sweden a few weeks ago

H/t Phil Plait Click here

College - an investment or consumption good, and why the difference could matter

People go to college to learn, form networks, build credentials, and thereby invest in themselves. But, a series of studies by Stacy Dale and Alan Krueger found that going to highly selective colleges (versus a low ranked college) does not matter for most students in terms of their job/wage outcomes. On the other hand, it does matter for minority students and students who come from less educated families. How could this be possible and what is the difference between the two groups? One potential explanation could be social capital. The former group has significant existing social capital via their family and so does fine no matter which college they attend. Their college decisions appear to be more like the purchase of a high brand consumption good. Meanwhile, better colleges provide the latter group an opportunity to build their credentials and social capital necessary to succeed. For them, college is more of an investment.

Does it make sense to have only one model of higher education to deliver these vastly different purposes?

One potential cost of this one-size-fits-all model is demonstrated in this recent study. The authors spend 1 year immersed in a large, public flagship school in the Midwest. They find that some students come to college to essentially party and have a good time (college as consumption), secure in their existing social capital. Another group of students, who do not possess the same social capital, sometimes get caught up in the consumption side of the college experience and under-invest in themselves?

Another implication of college as consumption can perhaps be seen in the rapidly rising cost of a college education. There are surely numerous drivers of college tuition inflation (see Baumol's cost disease), but here is what I have in mind: if a significant portion of students value college as a branded consumption good, it is likely that the price elasticity of demand is quite low, contributing to the rapidly rising cost of college. On the margins, this is changing the cost-benefit analysis for students for whom college is predominantly an investment good. For example, if I simply need a credential to signal to the job market, should I have to spend 4 years and upwards of $200K?

Just as students sit along the investment/consumption demand spectrum for college, it makes sense to think we should have post-secondary options that sit along the spectrum: cheaper options for course content and credentialing; expensive options similar to higher ed options today; and hybrid models in between.