Thursday, January 12, 2012

Robert Frank on Context Externalities and Positional Goods

Romesh Vaitilingam has in informative interview with Robert Frank at the VoxEU website, recorded November 2011, posted December 23, 2011. It is in podcast form, or if you prefer, there's a transcript. I'll first offer some excerpts in which Frank explains his position, and then offer some observations and criticism. Here's Frank:

On Darwin's exposition of why competition doesn't always lead to socially desirable outcomes

"I've made a fearless prediction that in 100 years time, people like you and me will check Darwin's name when they're asked to fill out a survey identifying the father of modern economics. ...  It will eventually be seen as an encompassing vision that includes Adam Smith's invisible hand theory as an interesting special case. ... So the antlers of the bull elk, for example. They are primarily to help males battle successfully against other bulls for access to mates. Darwin saw that males in most vertebrate species took more than one mate if they could. The qualifier obviously is the important step because if some succeeded, that means others don't take any mates at all, which is the real loser slide in the Darwinian scheme of things. So of course males fight bitterly for access to females. Antlers are the weapons for that particular species. And some mutations that coded for bigger ones were strongly favored in each case. They spread quickly, the mutations accreted. Now we get animals with antlers four feet across, weighing 40 pounds. That's too big for bulls as a group. Antlers don't grow forever, that's true. Natural selection puts a stop to the growth. There's an equilibrium, but it's not an optimum size when viewed from the perspective of bulls as a group. They'd much rather be half as big, because they're such an encumbrance when they're chased into a wooded area by wolves. They're easily surrounded and killed. If they could take a vote or put their hoof on a red button at the count of three, “all antlers shrink by half”, they'd have compelling reasons to do that. It's relative antler size that matters in battle, so it wouldn't affect the outcome of any fight. But they'd all be more mobile. They'd all be better able to escape from predation by wolves. From the perspective of the bulls themselves, that would be a good thing."

On "context externalities"

"I think more in terms of “context externalities”, I would call them. Is my car OK? Is my house OK? ... They're not socially scarce, but people's evaluations of them are very heavily context dependent. Is my house OK? I lived in a two room house in Nepal when I was a Peace Corps volunteer. It didn't have any plumbing. It didn't have any electricity. The roof leaked when it rained hard. It was nonetheless a perfectly OK house in that context. If you lived in that house here in the UK, you'd be ashamed for your friends to know where you lived. Your kids wouldn't want their friends to know where they lived. It would be a house that was by no stretch of imagination conceivably evaluated as being OK. It's just an inadequate house by the current standards. If you look at context externalities, they're not here or there, they're everywhere. They're more intense in some domains than others. ...[O]ne of the main results of looking at the world this way is you get arms races always that focus on the categories where context matters more. And they suck resources out of the categories where context matters less. In the house and leisure example, people would work longer hours thinking they're going to get ahead by being able to buy a bigger house. ... It's that kind of arms race that leads to the misallocation. That's why the invisible hand doesn't steer things to the best uses. ... Now the US family, on average, spends $28,000 on a wedding. That's in 2009, the most recent figure I could find. In 1980 the inflation adjusted figure was $11,000. Nobody could pretend that the people getting married in 2009 were happier because of that extra spending. It was just that the people at the top spent more. That led the people just below them to spend more. There was a cascade."

Policy implications? 

"I focus almost exclusively on remedies of the sort that try to make behaviors that cause harm to others less attractive to individuals by making them more expensive, usually by taxing them. That doesn't prohibit somebody from doing anything, so if somebody has got a really important stake in continuing to do what he's doing, he can but he pays the fee. ... Tax harmful behavior is the mantra that I repeat again and again .... Mainly the biggest remedy is to tax consumption at a steeply progressive rate."

Some reactions
As Frank says, he sees what he calls "context externalities" everywhere. I'm queasy about thinking of these social pressures as "externalities," that is, as market failures in which a tax reflecting the social costs of the externality would improve social welfare.  Claims that social pressures are making most of us consume items or do things we otherwise would not do are of course true, as they have been for every society since the dawn of time. But implicitly claiming that people's "optimal" decisions are the ones they would make if they had no social pressure at all, and social pressures must therefore drive them away from what would have been their optimal choice, seems like an offbeat claim for an avowedly "social science" like economics.

After all, the range of behaviors influenced by social pressure is very large: not just conspicuous consumption, but also many other decisions in various social groups: about working, or not; focusing on finishing certain levels of education, or not; taking certain drugs, or not; worshiping in a certain church, or not; becoming a parent at a young age, or not; and many others. In all of these cases, local and social pressures probablyl cause people to alter their behavior from what they would otherwise have done. But it would seem overly broad to call these all "context externalities" that are potentially ripe for policy intervention.
The alternative position usually taken by economists is that people are treated as having the autonomy and individuality to form their own preferences in a context that is mysterious and largely unexamined (by economists)--but a context that includes social pressures--and then economists study how demand based on these tastes and preferences interact with supply based on technology and production in the market. If some people work harder because they want to outdo their neighbors, that's not usually considered a "market failure." If a certain social group decides to live a highly simple life where they strip their consumption down to as little as possible, that form of social pressure isn't considered a "market failure," either.

I do like the idea of a progressive consumption tax that Frank emphasizes, but not because of  any argument about "context externalities." The emphasis on progressivity--that is, those with high incomes paying a greater share of their income in taxes--is to pursue goals of social equity. (Indeed, it seems to me that Frank's "context externalities" are best-understood as a way of saying that the marginal utility of income for those with high income levels is low, and so higher tax rates with those on high incomes are justified.) The emphasis on consumption, rather than income, is because the U.S. economy would benefit from a higher rate of saving, and a consumption tax falls only on what is consumed, not on what is saved.