Archive for the ‘economics’ Tag

Put a number on it

I’m usually happy to see numbers enter a calculation instead of bromides like “people here just won’t go for that” or “that’s not how Americans want to live their lives.” When people start talking about how much things really cost, for better or worse, I think that usually means we are starting to have a serious discussion. A few examples:

The Wall Street Journal had a recent article (via Market Urbanism) on how recent cuts to public transit in NYC had affected real estate sales in several neighborhoods. One real estate agent describes trouble selling properties that were served by a long running express bus route which was recently cancelled.

“The buyer who buys in Astoria is looking for a cheaper price and to get into Manhattan quickly,” said Ms. Palmos, adding that she is having the same problem with a condominium building in Upper Ditmars, north of Astoria. Apartments there that she said would have easily sold for $500,000 with the express bus nearby are now languishing on the market at prices about $420,000.

Anecdotes aren’t data of course. But it’s not a stretch to say that you could probably assign a rough number value to proximity to transit in New York. If $80,000 is the market value of that particular transit service for a single unit, imagine how much “value” was destroyed in that neighborhood by the loss of a bus.

Elsewhere, a new site Abogo (via Planetizen) will give you an estimate of the average transportation costs for a given neighborhood. Their goal is to help you “discover how transportation impacts the affordability and sustainability of where you live.” (Interestingly, the average transport costs for my neighborhood are exactly on with my “regional average” while my estimated CO2 emissions are nearly 20% lower than regional averages. I suspect this is due to the impact on their algorithm of a nearby subway stop in my area.)

While numbers like this are so general as to be of questionable accuracy, they do point to a welcome trend. Increasingly it seems that people are making the connection that sustainability and environmental considerations are not just little adjustments you make after you’ve set up your life the way you want it. But that our life choices like where we live have big, direct impacts not just on our environmental impacts but also on how expensive our lives are.

Transportation costs are notoriously difficult for the average person to estimate. The main reason may be that transport costs are an odd mix of small daily incremental costs (gas, car wash), larger annual costs (registration, insurance), and large unpredictable costs (repair, maintenance). This mix tends to lead to people underestimating what they actually spend on transportation which can have a large impact on the choices they make.

Meanwhile, Los Angeles Metro’s in-house blog The Source, wades into the debate on how well people estimate their own transportation costs. They don’t reach any conclusions beyond noting the confusion between daily incremental costs and overall costs and point out that transit users estimate their costs lower on average. I noticed though that taking a rough average of their poll respondents’ numbers gives an estimate of less than $200/month in transportation expenses. By contrast the Abogo estimate I got for the region is $719/month, nearly four times more than The Source’s readers self-estimate. Looks like there is still room for improving people’s awareness of their lifestyle’s costs.

Market Forces versus Regulation

Reuters reports on growing information showing that while the use of oil will continue to grow for some time, the world’s “oil intensity” (oil demand growth divided by economic growth) is decreasing and decreasing more rapidly. The point of the statistic is that for each incremental increase in global economic activity, the amount of oil used to achieve that growth is decreasing.

“Globally speaking, oil intensity has been declining by around 2 percent annually over the past decade…Our working assumption is that with fuel economy standards, fuel diversification and substitution … oil intensity lessens by just under 2.5 percent over the next five or six years.” – David Fyfe, head of the International Energy Agency’s oil industry and markets division

A key debate for anyone who thinks continuing or accelerating this trend is a good idea is the question of why this is happening. The report states that the declines are “spurred by high oil prices, moves to alternative fuels and measures to curb global warming.” But the article’s author notes that oil prices are “probably” a factor considering that “crude oil hit a record high of almost $150 per barrel in 2008 and are now fairly high historically at around $80.” I’d say that’s a pretty strong “probably”. Other than some fairly minor increases in fuel economy standards, nothing in the article points to any major cause for the decline other than the cost issue.

The experts cited generally predict that global oil usage will peak sometime in the next 10-20 years. But while this is generally good news, it’s a bit of “too little, too late” from my perspective. Stabilizing fossil fuel usage, GHG emissions, etc. is a start. But we’re going to have to actually reduce usage in the very near future. That means either massive, strict regulation of some kind or big price increases to bring market forces to bear on the problem. Given the minimal success we’ve had in the last generation with bringing much in the way of energy regulation to the table, I think we’re looking at pricing power as the one tool that might be able to have any meaningful impact on fossil fuel use. Carbon tax anyone?

Externalities

What are externalities?

In economic theory, an externality is an impact from a transaction that affects a party outside of that transaction. In a simple economic transaction the seller sets a price that reflects their costs, time, and other investment. The buyer decides if that price is at or below the perceived benefit (utility) they will get from the purchase. Standard free market forces will drive the price to an “efficient equilibrium” that will maximize utility for all parties. Simple, neat, efficient. Of course, real world transactions are rarely so simple. Nearly all purchases affect someone outside of the buyer and seller, some to a large degree.

Pollution is common example of a “negative externality”. When I buy a gallon of gas, I pay for the extraction, refining, transport, and other costs associated with making that item available to me. But when I burn it, I release a small amount of toxic chemicals into the air that have health and other impacts on those around me. The costs associated with that pollution is borne by a large number of people who had no say in the transaction. The seller and I have externalized those costs because they did not show up in the cost of the gas itself. If one could calculate the full impact of that purchase, in simple economic theory, in should be brought back into the cost of the product itself.

This was the general thinking behind many of the taxes and court judgments brought against tobacco producers in recent years. The argument is that they externalized the health costs associated with their product and profited unfairly because many costs were paid by people who did not choose to buy the product.

Of course, externalities can be positive as well. A store owner who launches an advertising campaign may benefit neighboring businesses by drawing more traffic to their shared location. Some positive externalities are not so simple or financial. A common example is in building a network. If I am the only person with a phone, it is useless. But when a second person buys one, it begins to have a potential benefit, so I have profited from their purchase. Of course, two phones in the world are still fairly useless. The network needs to grow to the point that there is a good likelihood that a person I want to call will also have a phone. As more people buy their way into the network, the value of the network to every other person increases as does the utility of their original purchase. Network externalities often have a tipping point  where they go from limited usefulness to good utility rapidly as the network achieves a critical mass of users.

Externalities can distort prices because all costs do not show up in the purchase. They also tend to cause an unfair distribution of profits (utility) to the parties that engage in the transaction. On a larger scale, they can also distort markets, development patterns, urban planning, even foreign policy. In the US, we subsidize home ownership through tax breaks. While the justification is based on the perceived positive externalities of more people owning homes, it does distort the relative prices of renting versus buying. Buying is encouraged, which increases demand for homes, spurring developments, spurring more lenders to compete for home buyers, spurring them to lower lending standards,…you see where I’m going.

Of course, part of the problem is that it’s often hard to calculate or fairly distribute the external costs. What are the externalities of a street light? Only a few people get the direct benefit of any particular light. But we all pay for the electricity, pollution, maintenance, etc. But how do you charge for a street light?

One big issue with externalities is that they tend to distort investment by forcing spending on issues that people may never have chosen to invest in. This distorts markets, leaving them in inefficient equilibriums, which in turn means that we are not maximizing utility across all parties.

I’ll be applying this concept to a lot of different issues in the future. But for now, let’s list a few possible situations and some of their unaccounted for negative (and positive) externalities.

  • Coal derived electricity – air pollution, GHG emissions, mountain top removal, jobs, cheap electricity that spurs economic growth
  • Car centric transport system – pollution, land use issues, health impacts/injuries, isolating development patterns, large financial investments that could be more efficiently invested elsewhere, personal freedom
  • Public transit & bike lanes – large financial investment by non-users, decrease in traffic congestion and pollution, better mobility for all economic levels (Note: a classic example of network issues. Large upfront investment that only begins to pay off once a critical mass is reached in usage)
  • Subsidized water – cheaper food, promotes excessive use driving up waste treatment costs, promotes planting and development planning that increase fire risk

Max Utility

efficiency1Probably about time to explain what the title of this blog means. Max utility is short for “maximum utility”, a fundamental principle in both economic theory and certain philosophical schools. I’m neither an economist nor a philosopher. But in this principle lies an interesting intersection between these two seemingly very different modes of thought as well as with a third key concept (and perhaps the secret subject of this blog), efficiency.

First to explain a few terms. In economic theory, utility “is a measure of the relative satisfaction from, or desirability of, consumption of various goods and services.”1 In short, a measurement of the benefit, happiness, satisfaction, etc. that someone gets from objects or activities. It’s commonly assumed that people will seek to maximize their own utility, meaning they try to make their life as pleasurable as possible, at least by their own definition of pleasure. Much of economic thinking is built on the idea that the purpose of commerce (economic activity) is to increase the utility of the people who engage in it. Ideally, our system is designed to “maximize” utility meaning that all people are getting as much satisfaction as is possible. This state can be described as “Pareto efficient”. A situation is said to be Pareto efficient if there is no way to rearrange things to make at least one person better off without making anyone worse off.2 While not everyone would agree that this is the best goal to pursue, almost all would agree that it is best to avoid situations that are not Pareto efficient. If you can increase someone’s satisfaction without decreasing anyone else’s, it’s hard to argue against making the change.

Of course, a key weakness of much of economic theory is that it attempts to define everything in economic terms; reducing notions of happiness or satisfaction to dollars and products. While I wouldn’t look to economics to guide us necessarily to a better world (I doubt many would argue they’ve been doing a good job of that lately), it does have tools and concepts that can aid in that pursuit. Economics does not do a great job of explaining what our goals should be. However, it can do an excellent job of figuring out how to prioritize issues, allocate resources, and build systems that will effectively and efficiently achieve our goals.

On the subject of goals, utility is most often associated with the philosophical school of thought known as utilitarianism. Utilitarianism is based on the idea that the “moral worth of an action is determined solely by its contribution to overall utility: that is, its contribution to happiness or pleasure as summed among all people.”3 So not only is the most economically efficient course the one that maximizes satisfaction, it is also the most moral course of action. While mostly referenced to the work of John Stuart Mill, this concept may be most widely known as expressed by Spock in his declaration that “the needs of the many outweigh the needs of the few, or the one.”4 While logic would seem to demand this course of action, in its simple form, utilitarianism does lead to some counter intuitive moral demands. If two people are dying of kidney failure, am I morally required to sacrifice my life and donate both kidneys based on the idea that two lives are worth more (and create more utility) than one? There are attempts, such as rule utilitarianism, to modify simple utilitarianism to account for these logical extremes.5 I’m no expert or visionary. I don’t think simple utility maximization can always tell us the most efficient or moral course of action. Arguments on morality have, and likely will continue on indefinitely. So I’m content to say that all other things being equal, pursuing the course that maximizes the happiness and satisfaction of all people seems like a good place to start.

So where do these concepts get us? They both build a worldview on the notion of efficiency. A system (moral or economic) that has inherent waste cannot fully maximize the satisfaction of its members. And this may be the most important lesson for us in the near future. The 20th century will be remembered for many things, but one feature that underlies many of them is the massive abundance of resources. Industrialization built a world unlike any seen before, and truly did pull vast numbers of people out of difficult, dangerous, low-utility lives. But many of these advances were built on the assumption of inexhaustible resources. When you assume that supplies of oil or water are infinite, the commodity is priced solely at the cost of extraction, not its “true” value, and you encourage a system that wastes more than it uses. When you assume that pollution has zero cost, the economic system will ignore it when trying to maximize utility and we’re beginning to see how far off we may have gone with that single miscalculation. Some blame capitalism itself for the problems we are now waking up to. It’s not difficult to see their point, though they often fail to show evidence of a better system. But like all logic based systems, it will only give you a valid answer if you set up valid assumptions. Otherwise, it’s ‘garbage in – garbage out’.

I believe we can use the power of capitalism, the free market, and notions of utility to pursue a better way. Input the true costs, limits, needs, and benefits into your calculations and I think we do have a chance to construct a system that actually does increase the average happiness of ALL people and not just those who have gamed or learned to manipulate the system to their benefit.

In the future I hope to explore ways that I think we can do that. Hopefully I’ll inspire some ideas or generate discussion that will lead to other good directions.

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1) http://en.wikipedia.org/wiki/Utility
2) http://wilcoxen.maxwell.insightworks.com/pages/225.html
3) http://en.wikipedia.org/wiki/Utilitarianism
4) http://www.imdb.com/title/tt0084726/quotes (paraphrased)
5) http://en.wikipedia.org/wiki/Rule_utilitarianism