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Tuesday, June 10, 2008

"Deadweight Loss" Needs to Die - Necessity vs. Wants

An arugment often cited for taxes (and sometimes cited by pigovian and gas tax advocates) goes like:

"Since the demand for GOOD X is inelastic, a tax on GOOD X is a good way to raise revenue because it does not lead to much of a deadweight loss."

The above statement is true. And if we take a look at the market for oil/gas, where both supply and demand are arguable very inelastic, we can see that the deadweight loss for a feasible tax increase could be quite small (as would any effect on output much to the shagrin of gas tax advocates). The benefit it is argued is the large amount of revenue the government can collect on the tax.

Maybe. But it's important to keep in mind, beyond the fact that government may not always be the best steward of our money (Iraq War ahem), that "small" deadweight loss is the net loss to consumer and producer surplus due to an action, and those concepts are something made up - by economists (so this is cause for concern).

Let's just foucs on consumer surplus for this purpose. What is consumer surplus? Well it is basically a made up concept that attempts to guage consumer well being. Applying our inelastic situation above to the concept is a way for economists to say, "this tax would not hurt consumers much, and the government would get huge revenues. " All seems to be ideal right? Wrong. Consumer surplus is determined by individuals' demand for a good at a given price, which is determined by individuals' utility, which is deterimined by consumer preferences, which is determined by the world we live in.

The problem with using deadweight loss and consumer surplus etc. as measures of wellbeing is the world we live in and how people perceive the world and its products.

In this world, gasoline is in the set of all consumption possiblities of a person's utility function. (That's econ speak for people value gas). Ok there. In this world, people have a prefernce for gas over other goods (ie, consumers can rank gasoline relative to all other things in their brain). Given this, we can get an idea of what persons' demand for gasoline may look like at given price points. People really value gasoline over and above many other types of goods and services because for most people in a modern society, it is a vital and necessary consumption that is largely unavoidable (if not completely so in the short-run). This in turns means the demand for gasoline is largely inelastic such that as the price of it goes up (via a tax for example), people will still consume a large amount of it.

The problem is in the philosophical understanding of the ideas of "value" and "welfare".

Value and welfare are determined by the world we live in, which is useful since economics typically assumes (as supply and demand does via preferences) that the world is one static moment in time and has therefore one equilibrium and that equilibrium is optimal. That is useful as far as constructs and some analysis goes, but it fails when talking about policy in many instances, since policy has to measure "value" as not just representing the welfare at a given point in time and for a given static set of preferences, but it has to measure value as something whereby welfare may change over time and preferences may change over time.

Most important though is that economists' measures of value and welfare are simply based on the fact that people have "utility" for something. But policy makers have to deterimine WHY they get utility from it in the first place and whether or not the loss in utility in one group is greater or lesser than the gain in another. Economists, by the use of standard models, can't do that. This is actually a problem in how "utility" is measured. Utility is not happiness (which again is a useful but often misused assumption). Utility is just a measure of indistinguishible needs and wants. But these needs and wants can't easily (mathematically) be compared across people or situations.

What makes a thing valueable in the first place economists put no stock in (but perhaps should take a cue from psychologists and do so). In the case of gas/oil, policy has to measure the utility of something that in large part is determined by the utility of necessity and not the utility of want.

Proposal 1:
Someone that gains from something (via a tax cut for example) they HAVE to have or do is surely more well off than someone who gains the same economic measure of value from doing or having something they WANT to do. (ceteris paribus of course - if you are talking about a gas tax holiday - that's just stupid).

Proposal 2:
Someone that loses from a policy (like a tax hike) regarding something they HAVE to have or do is surely less well off than someone who gains the same economic measure of value from doing or having something they WANT to do.

I think the above two proposals may be fairly common sense. The only reason consumer surplus doesn't fall much as the price of a good with inelastic demand rises is because the loss is just the difference in price (given be a tax or price rise) multiplied by half the loss in quantity demanded.

Whether or not gasoline is something we want or need is time-dependent (ie. dependent on preferences and needs of the day). And my sole assumption is therefore that gas is largely only valueable as a "need" based good at this time and will be for the forseeable future. It fits proposal 2 above.

Few would argue that people want to buy gasoline now (say for automobiles, to cook, to mow the lawn etc). Surely if it were just as cheap and useful people would prefer to use leftover trash to fuel their cars or perhaps gas of the methane variety, but the fact is, every day millions of people go to the pumps out of necessity. Unless you like to drink gasoline of course - which I don't think many do. Tax gas to a set price point, and while the direct consumer surplus may not fall by much, real consumer wellbeing surely would.

Herein lies a key difference between a tax on gasoline versus a tax say on cigarettes. Cigarettes are largely a utility of "want" not "necessity." Further, it has been deemed by medical professionals and the government to be an undesireable want. Therefore, it makes sense to tax cigarettes to reduce consumption, raise some revenue etc. The loss in real consumer wellbeing (a want or desire but not a need) is palpable but not on the same order in the long-run as addiction dies off. IE, absent a "need," the welfare loss of making something costly is not as great.

This is directly opposite of gas which may provide more or less revenue that could be shifted back to consumers (under a gazillion other assumptions) BUT would cause a direct harm because the fall in real consumer value would be great - the necessity would now be costlier.

Of course costly necessity items tend to also be regressive (hurt the poor more). This is another problem. A potentially bigger problem not talked about is that necessity items that become costly can have huge indirect costs. Again consider our gas tax vs. our cigarette tax examples. With a cigarette tax, few people are hurt other than cigarette manufacturers and smokers. Cigarettes aren't necessity items for production or consumption. But gasoline is a necessity item for consumption - meaning people will have to consume much the same amount and pay more for it - the costs of which are passed on to the family in terms of less income available to spend elsewhere (unless you rely on the government to give back revenues the right way, which I do not). The bigger effect here though is not on the consumption side, but on the supply side! Firms need gasoline to transport goods, to run factories. Oil is an input to many many types of goods in our economy. The ripple effect of higher gas/oil prices would be huge with respect to our production possibilities.

For all these reasons, typical textbook economics fails with regards to certain types of tax policy, and I believe the above shows how many economists may be applying partially unreliable models to some of today's most important tax policy discussions.

33 comments:

Robert Searle said...

With respect, you are offering old thinking when there is a desparate need for more advanced thinking in economics. I would strongly suggest that you might like to examine TRANSFINANCIAL ECONOMICS. It is my project which is still in development, and an authorative presentation in brief can be found at the p2p foundation entry site.

Comments both good, and/or negative are always welcome.

Garth said...

a. You didn't leave a link

b. I found that site anyway

c. I have absolutely NO idea what that gobblygook is saying. It sounds like a cult

d. Anyone who goes on someone else's blog and says basically, "you are stupid, I am smart, now please go see my site" must not be completely right in the head

Robert Searle said...

TFE is not gobbleygook, and it is certainly not a cult. But it is a new paradigm which exposes the inadequacies of the present economic system, and its primitive thinking about the nature, and purpose of monetary system.

Ofcourse, there will always be ignorant people who will want to destroy it even if they understood it as it cuts at the very roots of backward traditional thinking. This has always been the case for new paradigms of real value. Nothing new there!

It would be nice to have a more intelligent response rather than just an emotive one.

Garth said...

Well perhaps you would do better selling your project if you:

a. presented it in a way that makes more sense to the reader.

b. offered people to look at your idea without accusing them of "old thinking."

Robert Searle said...

I agree with the two points you make. It is hoped that in the process of time (within four years or so)the whole subject will become clearer especially the electronic inflation controls which could be operated by the banking system.

The key point to understand about TFE is that it realizes money inthe main exists as ELECTRONIC DATA. This means it can be DIRECTLY controlled. This is very important to grasp....

Ofcourse,in the past governments have simply printed paper money and had little control over it. This obviously created hyperinflation, and devaluation of currency (eg. the Weimar Republic, the French Revolution, and the Assignats, the American Revolution and the Continental notes et cetera)

In TFE the aim is to do something similiar but using electronic data which can be directly controlled unlike paper money. Thus, electronic controls have to be developed to ensure that capital is not devalued, and can t destroy the economy. The key ones are explained in brief in the p2p Foundation entry. Moreover, such electronic inflation controls have to be flexible enough to be acceptable for the present capitalist system thus allowing prices to self-adjust as naturally as possible.


TFE holds the key to many social, economic, and political problem but it does require a different understanding of money, and how it relates to our world.

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