Applied Microeconomics: The Normative Representative Consumer and Welfare Analysis

In a previous post, I pondered some questions related to using market demand functions to make welfare statements, following broadly Microeconomic Theory by Andreu Mas-Colell, Michael D. Whinston, and Jerry R. Green (MWG).

Making welfare statements about aggregate demand revolves around a few key concepts including a positive representative consumer, a wealth distribution rule, and a social welfare function. At a high level, these concepts seem to represent the technical assumptions and characteristics that need to hold in order to make most of the basic analysis of an intermediate microeconomics course mathematically sound or tractable for applied work. Here is a shot at some high level explanations:

positive representative consumer- at a high level, a hypothetical consumer who's UMP facing society's budget constraint generates a market or economy's aggregate demand function

wealth distribution rule - for every level of aggregate wealth, assigns individual wealth.

This rule or function is what allows us to write aggregate demand as a function of prices and wealth in order to move forward with the rest of our discussion about welfare analysis.

Examples given in MWG include wealth distribution rules that are a function of shareholdings of stocks and commodities which make wealth a function of the market's price vector

social welfare function (SWF) - this assigns utility to the vector of utilities for all 'I' consumers in an economy or market. W(u1,.....,uI) or can be written in terms of indirect utilities W(v1,....vI). 

Maximizing Social Welfare and Defining the Normative Representative Consumer

The wealth distribution rule is assumed to maximize society's social welfare function subject to a given level of aggregate wealth. The optimal solution indicates a particular indirect utility function v(p,w)

Normative Representative Consumer- a positive representative consumer is a normative representative consumer relative to social welfare function W(.) if for every (p,w) the distribution of wealth maximizes W(.). v(p,w) in the optimum is the indirect utility function for the normal representative consumer. 

For v(p,w) to exist, we are assuming a SWF, and assuming it is maximized by an optimal distribution of wealth according to some specified wealth distribution rule.

An example from MWG: When v(p,w) is of the Gormon form, and the SWF is utilitarian, then an aggregate demand function can always be viewed as being generated by a normative representative consumer.  

What does the farmer say...about seed choices? (Channeling Hayek)

I recently came across the following article in the Huffington post: Do Farmers Have Choices? by Jenny Dewey Rohrich who also has a very nice blog replete with some very good ag photography. The article discusses seed and hybrid selection issues based on actual responses from real producers. The responses are what I expected, of course they have a choice and its a tough one!

I've seen the concern out there that many people think big agribusiness and biotech companies have a gun (figuratively) to growers heads when it comes to seed choices and that justifies government interventions like labeling, more regulation, or bans on GMOs . As this article states, seed choice is a very complicated decision that involves many variables and traits. From the article, one producer describes their decision process that involves comparisons of hundreds of varieties from hundreds of corporations and mom and pop seed companies:

"First we go through the list of potential seed candidates every year comparing conventional, GM, and hybrids. Then we compare yields, cost per acre to keep plants alive, and then we throw in the variables: drought, flood, extreme heat or cold, early frosts, and untimely rains during harvest."

 The choice of what crops we should grow, how they should be produced in terms of management practices and technology, and ultimately the variety of foods we choose to consume is an example of what economists refer to as the knowledge problem. While it might be possible to patent a given trait or hybrid, no one company can get too firm a grasp on this knowledge problem, regardless of their market share in the seed industry today. (not to mention, no government agency would have sufficient knowledge either). Given the vast array of considerations in seed choice and management practices, there is always going to be an incentive for some supplier to cater to the unique needs of individual producers, as advances in genomics and technology drive production not farm by farm or acre by acre but inch by inch. That's also why the market has driven companies to treat hybrid selection like a 'big data' problem and they are developing multivariate recommender systems as tools to assist in this (like ACRES and FieldScripts). The market's response to each individual producer's unique circumstances of time and place also ensures continued diversity of crop genetics planted. Referring to the great article Blake Hurst recently wrote in The American, the synergy between genomics, big data, and modern technology in agriculture is amazing!

Another great comment from a seed dealer in the article states "Seed companies, including ours, bring to market those varieties and traits that farmers want to buy" and the author's statement "Farmers drive the demand for the seed that is researched, bought, and sold" pins down exactly how agricultural markets in the seed industry function as they should by solving the knowledge problem related seed choices and technology. That is truly the social function of markets and prices, as imperfect as they may be when we compare them to unrealistic and idealistic standards. The concerns related to monoculture and monopoly in the seed industry are largely overrated when these factors and trade offs are considered.

The comments made in the Huffington post article are based on a survey of farmers. Its likely not scientific, and my comments above are based on my own industry knowledge and personal experiences from past years working as a crop consultant as well as a few producers I know. I'd be curious to know what the mindset of a larger number of producers is on this issue.

See also my previous posts:  Big Ag Meets Big Data Part1 & Part 2 and  Monsanto Antitrust Case

Discussion of Labeling Genetically Modified Foods on Agritalk

Recently I was invited on AgriTalk to discuss the science and economics of labeling genetically modified foods and take questions from callers. You can find the show in the archives (April 4,2013). You can also find this via iTunes here: or iTunes https://itunes.apple.com/WebObjects/MZStore.woa/wa/viewPodcast?i=143629496&id=619537283

Is the Pink Slime Issue Just A Matter of Consumer Preferences?

Previously I made a post entitled ‘Pink Slime: What is Seen and Unseen.’ Having made its way through some social media channels, it has received some interesting comments. A couple common arguments that seem to stand out, not only in my posts, but also in other articles could be generalized as follows:

"This is how the free market works. Supply chains will adjust. This isn't a unique situation that requires any further analysis. It doesn't stand out among the millions of other choices consumers make on a regular basis between numerous other products."

"Why even mention it. So what if consumers are uninformed. Education and evidence are really irrelevant to this issue (or any issue for that matter) because people are irrational. "

These comments really help to clarify the real issue here. The supply chain is really at the heart of the issue for many of those slamming pink slime. Its not pink slime in and of itself that is their only problem. They don't like modern food supply chains (think ADM, Monsanto, Wal-Mart), and if they get their way, our food supply chains would more closely resemble the balkanized gasoline market, with all of the restrictions and the required bottlenecking boutique of gasoline blends etc. and of course the high prices.

If I thought this were simply about food preferences, food choices, and consumers making decisions based on those preferences, and the markets  responding, then of course this would all be a moot discussion. Those that simply choose to avoid finely textured lean beef, are not necessarily the problem. The goal of the purveyors of the pink slime propaganda isn't simply to persuade consumers to choose alternative products, but to build the sentiment that will support coercive government intervention in the market place. (as has happened in other states with laws regarding 'child labor', ‘dust’ regulation, 'CDL  requirements for operating farm machinery', 'battery cages' in egg  production, 'gestation crates' in pork production, fat taxes, sugar taxes, salt  taxes, hormones, antibiotics, biotechnology...pick your technology,  ingredient, and regulation).

From fiction to reality, biotechnology, 'pink slime', pharmaceuticals, modern  food supply chains and processing, (name your villain) are all contemporary  analogs to 'Rearden Metal' from the book Atlas Shrugged. When Dagney had to go out on her own and  start the 'John Galt Line' it was in fact largely in part a response to the loss in demand as a result of the dynamics of public opinion regarding Rearden Metal, penalized for being virtue. Given the negative public perception and the heavy burden of the regulatory environment for the railroads, Taggert Transcontinental stock was plummeting.

Recognizing this dynamic between public opinion, market forces, and the regulatory apparatus and making it known is essential to the  perpetuation of a free society. As Don Boudreaux of George Mason  University states so well:

"What matters mostly – overwhelmingly – is the climate of opinion. And so affecting the climate of opinion for the better seems to me to be, by far, the only long-term means of ensuring the stability of a free society."

But, can we really affect public opinion for the better? Are people obstinate and irrational in their views?  Is evidence irrelevant?

 "Reason, my dear fellow is the most naive of all superstitions...logic is a primitive vulgarity" -Dr. Pritchett, Atlas Shrugged.

 Is evidence always and everywhere irrelevant, or is it just minimized by propaganda and undervalued in general?  Does the assumption of perfectly rational behavior have to hold to make these arguments, or to approach these issues utilizing the analytical way of thinking that economics teaches?  Should we just assume that all behavior is mindless and throw in the towel?  That would certainly relieve many of us a lot of stress and of course, that's what the interventionists like Dr. Pritchett in Atlas Shrugged wanted people to think. They desire a public that has grown disdainful of facts and evidence, looking to intellectuals and politicians to make things right.

But, as Steve Horowitz points out in his textbook 'Lessons for the Young Economist':

“When we look at the world and try to make some sense of it, one of the most basic and crucial distinctions we all make—usually without even realizing it—is the difference between purposeful action versus mindless behavior...The lessons in this book apply to purposeful actions performed by

conscious people who have goals in mind.”

As Dr. Horowitz goes on to explain, even if people often 'miscalculate' or aren't "perfectly rational people" the logic of economic thinking holds. As Economist Peter Boettke states:

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis."

And in fact, blogs, even 'micro bloggers' with just a few thousand imprints or less, all have a role to play in adding to this pool of knowledge. Even if they are preaching to the choir (i.e. read mostly by like minded individuals) they provide an arsenal of ideas that help everyone to better structure their thoughts, and share them with others, and occasionally someone that may actually change their mind.  Not everyone is a general like Bodreaux and Roberts at Cafe Hayek,  but given this war of ideas and the role they play in a free society, every soldier counts. Post by post, line by line. While its origins are disputed, the quote often attributed to Thomas Jefferson is no less true:

"The condition upon which God hath given liberty to man is eternal vigilance; which condition if he break, servitude is at once the consequence of his crime and the punishment of his guilt."

The CPI Couldn't Keep Up With Steve Jobs

From basic principles of economics, we know that measures of inflation based on the CPI are biased because of substitution effects, the introduction of new goods and services, and unmeasured quality changes.

Here is some related insight from Russ Roberts post Stagnation or Mismeasurement at Cafe Hayek: (this was in 2007)

 It is not just a question of the number of new goods and services–it is the pace of innovation  within product categories and how much each of these makes it hard to measure prices with any accuracy....The iPod will be six years old next month. The newly released iPod Classic with 160 GB of memory is $50 cheaper than the original iPod, holds 40 TIMES more songs and also plays color videos and displays photos. It is smaller, lighter and has a better battery.

Efficient Markets and Prices

‎"I prefer true but imperfect knowledge, even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge" - F.A. Hayek

"The financial crisis invalidated a naïve notion of "efficient markets," but the most sophisticated version is still viable. Whereas the invalidated version holds that markets never err and always adjust instantaneously, the sophisticated version, associated with the ideas of Adam Smith and F. A. Hayek, holds that markets mobilize individuals to realize gains from trade and to innovate and thereby produce generalized prosperity."
"In the 1940s, Hayek warned his fellow economists of the misleading standards of perfect competition and static efficiency in assessing the market economy. As he wrote in Individualism and Economic Order, "[T]hese adjustments are probably never 'perfect' in the sense which the economist conceives them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency" (1948, 87)"

http://www.independent.org/publications/tir/article.asp?a=762

"The great free market economic thinkers from Adam Smith to F. A. Hayek never argued that individuals were hyper-rational actors possessed with full and complete information, operating in perfectly competitive markets.... Efficient markets are an outcome of a process of discovery, learning, and adjustment, not an assumption going into the analysis."

http://theeuropean-magazine.com/348-boettke-peter/349-the-legacy-of-smith-and-hayek

Gas Prices, Long Lines, Parachutes & Profits

Recently, from the New York Times:

"The crisis rolled on through the summer. Irrationality set in. All over the country, people wasted gallons of gas waiting in line for the gas they were afraid wouldn’t be there the next week. The crisis was the only news story anyone cared about. A protest outside Philadelphia turned violent. People stood guard beside their cars at night against thieves who siphoned out fuel."

From Atlas Shrugged:

“Money is a tool of exchange, which can’t exist unless there are goods produced and men able to produce them….when money ceases to be the tool by which men deal with one another, then men become the tools of men. Blood, whips,and guns; or dollars.”

Recently, some clever bureucrats have gotten together to form a group known as the 'Oil and Gas Price Fraud Working Group.'

As quoted at the Knowledge Problem blog:

"And I would also note that one of the things the Attorney General task force will be looking at is coordinating with state attorneys general to make sure that we don’t have a what I’ve heard described as a “rockets-and-parachutes phenomenon,” where prices at the pump rocket up when oil prices rocket up, and yet they come down in a parachute fashion when oil prices go down. So we want to make sure that a drop in oil prices is appropriately reflected in a drop in gas prices at the pump."

Based on what I just read in the NYT above, I hope these guys don't take themselves too seriously. Of course, many people get upset about things like Exxon's recent profits reports, but as economist Mark Perry point's out at Carpe Diem, revenue from gas taxes (based on recent numbers) is almost 7 times Exxon's profit on a per gallon basis. (and we still have budget deficits).

It turns out, that consumer behavior in a competitive market (not greedy gas station owners, speculators, or oil companies) explains the "rockets and parachutes" phenomonon.

 'Rockets and Parachutes (or feathers) and research here:

ASYMMETRIC PRICE ADJUSTMENT AND CONSUMER SEARCH:

AN EXAMINATION OF THE RETAIL GASOLINE MARKET

MATTHEW LEWIS

Department of Economics

The Ohio State University
(forthcoming Summer 2011 Journal of Economics and Management Strategy)

"The model predicts that consumers search less when prices are falling. This reduced search results in higher profit margins and a slower price response to cost changes than when margins are low and prices are increasing."

and here:

"Contrary to public opinion and previous work suggesting that collusive behavior was the cause behind asymmetric pricing, this paper shows that it can well be the outcome of a competitive market"

Rockets and Feathers
Understanding Asymmetric Pricing
[Job Market Paper]
Mariano Tappata
UCLA
January 2006
 
Other references:
That ’70s Energy Crisis

By SUSAN STRAIGHT
Published: April 30, 2011
The New York Times

National Health Care Links

Markets generate prices which reflect trade-offs based on the knowledge and preferences of millions of individuals, and provide incentives to act on that knowledge to allocate resources. Eliminating the price mechanism through national health care only takes the information and coordination problem away from markets, and places it in the lap of government. With government, decisions are based on the limited knowledge and preferences of a few bureaucrats.


From the Journal of Physicians and Surgeons
Here, ( JPANDS)

"When the government denied Mr. D. the new medicine on the
grounds that the subsidies would cost too much, he offered to pay
the full cost of the medicine himself. He was denied the option to
pay full cost out of his own pocket because, the bureaucrats said, it
would set a bad precedent and lead to unequal access to medicine."

"discoveries of this magnitude are ruled out in Sweden:
In our budget-governed health care there is no room for
curious, young physicians and other [medical]
professionals to challenge established views. New
knowledge is not attractive but typically considered a
problem [that brings] increased costs and disturbances in
today’s slimmed-down health care…. Primarily the system
endorses health care regions and administrative directors
who can show a surplus in their budget. Quality of care and
patients’well-being are second-tier goals."

NATIONAL HEALTH CARE IN CANADA

CBC NEWS here

"Overcrowding in the emergency ward at Royal Columbian Hospital in New Westminster has become so bad that patients are being forced to sleep in closets, says a senior surgeon."

"There are patients that are literally in closets. They're in the nurses' lounge, where the nurses go to have coffee, there are patients in there," said Dr. Bertrand Perey, the hospital's deputy chief of surgery."

"In other words, we have an acute shortage of beds in all wards, surgeries have been cancelled because of this overcrowding and it's becoming a much worse problem than it ever was before."

here

“It’s becoming clearer that Canada’s current health-care system cannot meet the needs of Canadians in a timely and efficient manner, unless you consider access to a waiting list timely and efficient,” Esmail added.

NATIONAL HEALTH CARE IN THE UK

From the BBC :

"Dr Rustin said that before he sees a patient he has to check their postcode to see which health authority pays for their treatment. He says he can only then prescribe the drug if he knows the authority will fund it.

He said authorities have to make a crude calculation.

"They want to show that we can improve duration of life with a new drug and they then try to calculate the extra duration of life," he said.

"If you get an extra year of life for less than £10,000 then it is generally considered that that is a reasonable buy."

From the Telegraph, here ,

From a Patient in the UK:
"In two hours time I have to attend a clinic in a town 15 miles away for follow up mammography. There is no mammography available in the borough where I live,pop 380,000.I worked hard to raise funds for a breast cancer unit in our DGH, that has all now been shipped out to a PFI hospital in another town. This despite a petition of 50,000 names asking for this and various other departments not to be closed"

here ,

"THE controversy over hospital waiting lists will continue to dog the Government in the forthcoming election campaign, a study by mathematicians claims"

here

"To commemorate the 60th anniversary of the founding of the NHS, Gordon Brown plans to introduce a "constitution" setting out the rights and responsibilities of our healthcare system"

What this seems to amount to in practice are the Government's rights to refuse treatment, and the patient's responsibilities to live up to what the state decides are model standards.

UK Daily Mail

"plans by NICE, the Government's drug rationing body, mean no life-extending therapies will be available to new patients because the cost of the most expensive exceeds its threshold of £30,000 per head"