And further on price elasticity

Seamus reminds us that we need to look at relative elasticities.

Brian Easton provides advice that the Law Commission deems "helpful". His advice is:

It is generally assumed that the demand for alcohol is largely price inelastic. However, it is believed that the main groups whose consumption is sensitive to changes in price are:

• the young;
• binge drinkers; and
• heavy drinkers.

Easton is right that alcohol consumption is relatively inelastic: around -0.44 for beer, which means that a 10% increase in price reduces consumption by 4.4%. But we tend to expect that the folks whose consumption produces greatest harms would also be the folks whose consumption is relatively least elastic. Price elasticity basically tells us how many substitute commodities there are out there for the consumer. If the individual views there as being no substitute for alcohol, his price elasticity will be very low; if he views a Coke as being a not too bad alternative, his price elasticity will be rather high. And, indeed, what numbers I've seen on it show that heavy drinkers are less price elastic than are moderate drinkers.

If we decide to be charitable, then Easton's just reminding us that even heavy drinkers are price sensitive. Which is true. But they're less price sensitive than moderate drinkers. Even if you accept the premise that there are some heavy drinkers who could be made happier by virtue of a tax increase that helps to keep them on the straight and narrow, moderate drinkers' consumption is more strongly affected. Suppose we have a 10% price increase. Moderate drinkers reduce their consumption by about 4.4%; heavy drinkers reduce their consumption by about 2.8%.

Now, how much does a heavy drinker benefit from a 2.8% reduction in consumption? How much is a moderate drinker harmed by a 4.4% reduction? And what are the relative proportions of both in the country? BERL said that 1/6 are "harmful" drinkers, which I still think is a gross overestimate of the true proportion. But let's take it for now. It then has to be the case that a single heavy drinker reducing his consumption by 2.8% is benefited by at least six times as much as a moderate drinker is harmed by a 4.4% reduction in his harmless drinking for the tax increase to potentially be efficiency-enhancing. If the true proportion is 1/10, change it to 10 times. Recall that for the wowsers, consumption of 2 pints per day is harmful; the midpoint of BERL's "high risk" category is 110 grams: 11 standard drinks, or about 5 pints. How big a price increase would be necessary to get the high tail consumers down to "moderate" levels? Well, they'd need to reduce their consumption by about 65%. If your price elasticity of demand is -0.28, then you need a 232% increase in price to reduce consumption by 65%. And of course for that level of a price increase, the moderate drinkers reduce their consumption pretty much to zero. All of these numbers are just back of the envelope, for now. But I don't think they're far out.

The LC cites a WHO study arguing that heavy drinkers are no less elastic than other drinkers. A quick check shows the WHO is looking at 2-3 studies while the above-linked one is a meta-study of more than a hundred, with results that are near identical to another meta-study of similar magnitude. The latter, forthcoming in the Journal of Economic Surveys, doesn't give a breakdown between heavy and light drinkers, but has near identical estimates of average elasticity. I give a heck of a lot more weight to a serious meta-study, and especially when two of them give near-identical results, then to a couple of pieces picked from the potential list. If there are more than a hundred studies, you can always find a few that give you numbers you like.

Looking more closely at the Law Commission's preferred WHO finding, ... wow. Terrible work.

While heavy drinkers are sometimes thought to be likely to be less affected by price, the Committee found that the evidence does not support this belief, with higher prices affecting the amounts consumed by frequent and heavy drinkers. This finding is supported by a large body of evidence which has shown an impact of prices on harms caused by alcohol, also indicating therefore that heavier drinking has been reduced (34). Natural experiments that have occurred recently in Europe as part of changes required as consequences of economic treaties have shown that as alcohol taxes and prices have been lowered, so sales and alcohol consumption have increased (37). In some jurisdictions in Europe, special taxes have been introduced for spirit-based sweet premixed drinks, in response to increases in young people’s drinking (38). These have led to reductions in sales and consumption of the specific drinks.

Nothing in the paragraph supports the WHO's argument. Nothing. Demand curves slope downwards, that's all they're saying. All groups are somewhat elastic in that demand drops when price increases. The question at hand is whether moderate drinkers reduce their consumption by more than do heavy drinkers, and they provide zero evidence supporting their opening claim. I cannot see how the Law Commission dismissed the findings of the meta-study based on this paragraph.

Shocking.

Oh Treasury, Why Hast Thou Forsaken Us?

Reading the Law Commission report on the review of alcohol taxation and regulation that Eric linked to yesterday, I noticed this sentence in the Treasury advice to the Commission:

Within existing constraints then, the best proxy for a progressive Pigouvian tax is an alcohol excise that equates to the net costs of the consumption of alcohol for society as a whole.

The constraints they refer to are the fact that the external costs of alcohol are typically higher for large users than for low users, so that ideally large users should pay a larger tax per drink than low users. Let’s leave aside the fact that a Pigouvian tax should be set to equal the marginal social cost not to equate tax revenue with the total social cost. My problem with this statement is that if one is constrained to apply the same tax to high-social cost and low-social cost users, the optimal policy needs to ask about the relative responsiveness of demand to price of the two groups. Let’s imagine that high-social-cost users have relatively inelastic demand and low-social-cost users have more elastic demand. Then a Pigouvian tax will have little effect in reducing the harmful consumption of the former group and a large effect in reducing the non-harmful consumption of the latter group. The optimal Pigouvian tax in this world would be much lower than one that equaled net social marginal costs. Indeed, in the extreme case where the high-social-cost users had demand that was completely unresponsive to price, the optimal Pigouvian tax would be zero!

Social science, done honestly

William Dickens has spent the last several years thinking hard about racial differences in IQ. The stylized facts didn't make much sense to him, taken together:

• Large differences in average intelligence by race (about 1 standard deviation)
• High estimates of heritability of intelligence and little discernible lasting effect of environment
• Rising intelligence over time (the Flynn Effect).

If variance in intelligence is largely explained by genetics, not by environment, how can we explain the Flynn Effect, which happens far more quickly than could be explained by any evolutionary story?

Dickens worked with Flynn to come up with a model that allows for complex interactions between genes and the environment that would fit the three stylized facts. The model works as follows, and is nicely described here. Kids with small initial differences in genetic endowments sort into more or less cognitively demanding environments. The ones in the more cognitively demanding environments reinforce their initial advantages. Because genes cause the initial environmental sortition, all then loads onto genetics in variance decomposition. But the observed differences are still a function of both genes and environment. And, if one group systematically has poorer access to cognitively demanding environments, then large group differences can be observed despite there being small underlying genetic differences. If the average environmental cognitive complexity increases for all groups over the period, we get the Flynn Effect.

Cute model and seems plausible. Bill then took the model to the data. Or, rather, took one implication of the model to the data: a full test would require some rather expensive experimentation. If the model holds, then a decomposition of variance into transient environmental effects, permanent environmental effects, and measurement error should show that at least some differences across siblings come down transient environmental effects. Instead, he found most of the environmental variance is permanent with the rest being measurement error (see slide 43 at the above link).

BUMMER! (Did I mention that one of the “advantages advantages” of tightly linking your theory to your empirical work by modeling is that you can be proved decisively wrong?)

Moreover, differences across identical twins in childhood are almost entirely measurement error. So if one twin randomly is assigned to a more cognitively demanding environment in childhood, we can't see any effect of it in the data.

And so Bill heads back to the drawing board, working on a new model where folks switch environments to match the one that meets their current level of cognitive ability, but where there's noise in the process and fewer opportunities for change as time goes on.

That's how social science, or any science, is supposed to be done. Hypothesis leads to test leads to starting over if the hypothesis is rejected. DeLong and Lang worry that all economic hypotheses might well be false because of publication bias; Ed Leamer worries that folks choose the method that gives them the results they want. Nice to see folks who work against both. And, entirely consistent with other observations on Bill, who visited here as an Erskine Fellow a couple of years back and who derived results on a scratch-pad while role-playing a low-intelligence half-ogre named Grissumpf in Bryan Caplan's excellent all-economist D&D campaign (I was a sage-assassin who threatened his way into sage school, charisma of 4). Good times.

Law Commission

The Law Commission released its report on the review of alcohol taxation and regulation. I've been teaching all day and so haven't yet had a chance to look through it thoroughly. I note though that the Law Commission thinks it appropriate to seek advice from Brian Easton as an independent authority on the social costs of alcohol to help resolve the differences between the BERL report and the Crampton/Burgess critique. Ahem. Will be interesting to read the rest of the paper.

Questioning education

Over at Inside Higher Ed, Mario Rizzo asks some pertinent questions about the push to have ever-increasing proportions of the population pass through universities.

At the risk of being accused of taking away the party punch bowl, readers should know that I stand to benefit a great deal if more Americans partook in the college experience since I teach large numbers of introductory and intermediate economics students for a living.

Despite this, he argues against President Obama's call for increased higher education. Worth noting:

• There are diminishing returns to aggregate educational attainment
• Education is costly
• The more low quality students are pushed through low quality schools, the greater the returns from attending prestigious schools to differentiate yourself
• A good portion of college is consumption for the students
• Richer countries have higher rates of tertiary completion, but causality is difficult to prove; there are notable counterexamples to received wisdom
• Education is a good, but so are other things: there are opportunity costs. As Rizzo asks,

  Does it make sense to sacrifice more and better carpenters or professional baseball players just to lead the world in college completions? Perhaps I am overplaying that hand. But there are many ways for individuals and societies to improve their human capital and productivity without relying on political forces to put more people through college.

Human capital is important, but higher education is only one way of getting it.

Nothing new under the sun

I thought I'd discovered a new word to describe an ongoing problem in the Crampton household. Turns out, someone else was there three years before me. It's still a good word though. Narcokleptic. Pertains especially to theft of blankets, leaving a cold Eric.

The word deserves wider usage. Enjoy!

Electricity Report: Who Paid the $4.3b?

The slides from my talk at the Institute for the Study of Competition and Regulation (ISCR) on the Wolak report into the electricity industry are now posted on ISCR’s website.
This is the study that produced newspaper reports like the following:

Power companies face public outrage after a Commerce Commission report said they had overcharged customers $4.3 billion.

I will blog a bit over the next few days on why I think the $4.3b is heavily overstated, but first it would be useful to correct a misunderstanding in the way that the study has been reported in the press.

In New Zealand, wholesale electricity prices are determined every 30 minutes in an auction market in which electricity generators submit offers for how much electricity they would be willing to supply at different prices at different injection points on the national grid, while buyers submit bids to buy electricity at the exit points on the grid. The computer-based market maker then sets the prices to equate supply and demand taking into account energy loss along the transmission network. In principle, generators can submit offer curves that are higher than their true willingness to supply (essentially pretend to be willing to supply less than they actually would like to) in order to push up the price. In the retail market, electricity retailers buy electricity from this wholesale market to sell to final consumers, usually at a price that is fixed for 12 months or more.

The Wolak study looks at the wholesale market, not the retail market. The $4.3b is an estimate of how much electricity generators have overcharged wholesale buyers. But who are those buyers. A small percentage are large industrial final users who purchase directly from the wholesale market at spot prices. But the overwhelming majority of purchases are by retail companies, who are mostly also the big generators. That is, the unfortunate purchasers that Wolak estimates have been overcharged $4.3b by the four large generator companies—Meridian, Genesis, Mighty River Power, and Contact—are, in fact, none other than Meridian, Genesis, Mighty River Power, and Contact!

A full study of the retail industry might reveal that there is pass through from wholesale overcharging to retail prices, but such a study has not been conducted, and it is by no means clear theoretically that such pass through would be profit maximising behaviour in a vertically integrated industry.