Author: Edward Thater

Why No Hate for Job-Killing Advertising?

/ Edward Thater / Leave a comment

As the various branches of the federal government continue to struggle to find ways to put the nation’s fiscal house in better order, a key component of these discussions is whether and how to make tax reforms. If you spend more than five minutes watching Sunday morning news, you know that some policymakers are pretty insistent that taxes cannot be raised because taxes “kill jobs.” My response to this is, “So what?” A lot of economic actions “kill jobs,” many to a larger degree than taxes do, but no policymakers are looking to ban those actions as bad for the economy.

Now, don’t misconstrue me here, dear readers. I am all in favor of tax reform. I think our federal taxation system is too complicated, has far too high a level of compliance costs, and is otherwise a pretty bad way to go about raising government revenue. However, unless and until there is a political consensus about where and how much to cut government spending, there is a legitimate case to be made (one that you don’t necessarily need to agree with) for increasing our current tax revenue to cover more of the costs of government so that we can borrow less. (As an aside, the debate around government spending is usually off base as well. The question should almost never be “how much should we spend?” but rather “are we spending the correct amount of money on the correct things?” But that is a topic for a different blog post.)

It is quite well established that taxes reduce production and reduce jobs. Let’s say the government imposes a $10 tax on widgets. Let’s also say that for the purpose of this example, the market conditions are such that the price of widgets rises by $5. This means that consumers bear half of the cost of the tax through higher prices, while producers bear half the cost of the tax through a hit to their bottom lines. (A fuller discussion of tax incidence and why producers can’t simply pass on 100% of the tax’s cost to their consumers is beyond the scope of this particular post.) However, this means some consumers will be priced out of the widget market, as they will be unwilling and/or unable to pay the new, higher price. Likewise, facing diminished demand and the hit to their bottom lines, producers will scale back production or leave the widget business entirely. That means fewer people employed making widgets. Economists call this loss of economic activity (fewer people buying widgets and fewer producers making widgets) deadweight loss, and it does translate to fewer jobs on an economy-wide scale.

However, lots of other things cause deadweight loss besides taxes. Take, for example, monopolies. The reason monopolies are generally considered bad is because they maximize their profits by creating artificial shortages. This in turn creates a rise in the price per unit (shortage of supply drives prices up), which increases the monopoly’s profits. The monopoly could create more units and sell them at a lower price to people who want the units while still turning a profit, but it wouldn’t be as big of a profit as the one it gets from its artificial shortage. Thus, unchecked market power, which is the ability to control the market price by controlling the quantity produced, creates deadweight loss.

While monopoly is one extreme example of market power, millions of firms in the U.S. economy enjoy some level of market power that allows them to withhold production in order to increase profits. And what causes these firms to have this market power they exercise? For most of them, it is simple advertising.

Companies advertise to build their “market share” by attracting new customers and by building brand loyalty. This, in turn, leads to those businesses commanding a portion of their markets, which allows them to withhold production and make more money. If you’ve ever known someone who rushed to the store to buy the latest Disney DVD release before it goes “back into the vault,” you’ve seen this technique in action. But it’s not just Disney. Firms of all sizes use similar techniques to make more money.

So why aren’t any politicians railing against job-killing advertising? After all, given the millions of firms with some level of market power, the number of lost jobs to advertising is at least as big, if not bigger, than the number of jobs lost to taxes. The obvious political answers are that (a) few policymakers in D.C. have had any sort of economics training, and (b) business hate taxes, which hurts their balance sheets, but love advertising, which pads their balance sheets at the expense of their competitors, so they tend to lobby against the one and not the other.

There are many good reasons to support a smarter tax system with lower rates and a broader base. Such a system would cause less deadweight loss and be better for the economy in the long run. But unless you’re willing to go the extra step to crusade against any economic activity that causes deadweight loss, you should find a better argument to lower taxes.

In Memoriam: Ronald Coase

/ Edward Thater / Leave a comment

Nobel Laureate Ronald Coase died last month at the age of 102. I’m sure that most readers of this blog have never heard of Ronald Coase, and I’m equally sure that most of the few who have heard of him likely forgot his name less than an hour after completing their microeconomics exam. Coase was one of the founders of the Law and Economics movement, the goal of which is to encourage more economic analysis when crafting legal rules. As a law student whose pre-law graduate work was primarily in economics, I have a lot of respect for Coase and feel the need to spread his legacy to a wider audience.

Coase’s most notable contribution to economic theory was in the analysis of externalities, an economic concept I will attempt to briefly explain. Markets are essentially social price-setting mechanisms, and when everything is working well, a market will set a price that balances the costs of producing a good with the benefits of consuming that good. This, in turn, ensures an economically efficient distribution of resources. However, markets can only do that when all the costs and benefits are factored into the transaction. Sometimes, costs and benefits of the transaction are external to market participants. The classic example of a negative externality is pollution. If a factory can dump its waste in a nearby stream for free, the management doesn’t account for the effects of this water pollution when deciding its prices. Thus, because the market price of the factory’s goods does not factor in the very real social cost of production, there will be inefficient overproduction by the factory, while the public who bears the cost of the water pollution go uncompensated.

Before Coase, the standard economic solution to this problem was to impose a suitably high tax so that the producer would internalize the external costs. Either the producer would modify its behavior to account for the true cost of production, or it would provide a revenue stream to compensate the victims of the negative externality. Coase, however, turned the traditional analysis on its head by noting that the real problem here is that the different parties both want to use the same resource for different purposes.

Coase gave the example of a doctor and a confectioner who have adjacent offices. During the day when the doctor is trying to see patients, the confectioner uses machinery that makes loud noises and causes vibrations sufficient to disturb the doctor next door. Coase said the problem is not that there is a social cost imposed by the confectioner that must be taxed away, but rather that both the doctor and the confectioner want to use the same space for their two businesses in ways that are incompatible. It is true that the confectioner is disturbing the doctor’s practice with his noise. However, it is equally true that the doctor’s practice is disturbed by the noise only because it’s located next to the confectioner.

Coase’s real genius was in his solution to this problem. Under Coase’s analysis, the parties themselves can negotiate an economically efficient solution without any outside help. Let’s say that, in our example, the doctor has the right to force the confectioner to stop running the machinery and making the noise. The confectioner can instead offer to pay the doctor to move to a new office. If the confectioner derives greater economic value from the location than the doctor does, they should be able to come to a mutually agreeable price that will get the doctor to agree to move. If, however, the doctor derives greater economic value from the location, no price the confectioner is willing to pay will be enough to convince the doctor to leave, so the confectioner will have to find a new place to ply his trade. In either case, the solution is economically efficient because the externality is resolved while the party who derives the greater economic value gets to stay. The exact same analysis would apply, only in reverse, if the confectioner had the right to make as much noise as he wanted and the doctor attempted to pay the confectioner to move.

Unfortunately, Coase’s elegant solution, which is called the Coase theorem, only works if there are well defined property rights (e.g., either the doctor has a clear right to stop the confectioner’s noise or the confection has a clear right to make noise) and if there are relatively low transaction costs (e.g., there are only a few parties, all of whom are willing to negotiate in good faith). This doesn’t happen as often with real life externalities as we would like. Nonetheless, it’s a great example of how a simple change in perspective can suggest a new solution to an old problem that is revolutionary in its time, only to become common sense a generation or two later. In my book, that is a legacy worth remembering.

Calculating the Economic Cost of the Federal Shutdown

/ Edward Thater / Leave a comment

Let’s set aside for a moment the politics of the shutdown.  Regardless of political views, we can all generally agree that the shutdown costs the economy something.  The bigger question is what that number is.  The national media have more or less universally been reporting a number calculated by IHS Global Insight, a Massachusetts-based economic forecasting firm, of $12.5 million per hour.  For you non-mathematically inclined readers, that works out to $300 million a day. The problem with that number is that it represents only the dollars that the federal government spends on goods and services each day.  It does not represent the actual economic costs of the shutdown.

The main reason for this is something called the multiplier effect.  One dollar of spending by any economic actor does not just raise GDP by that same dollar.  Instead, my spending is someone else’s income that the next person can spend.  If I buy a hot dog and a soda from the vendor down the street, I spend $3.  The hot dog vendor, in turn, uses those $3 in income to purchase buns for tomorrow’s sales.  (Yes, I know, the buns cost more than $3.  The idea is that part of the money to buy the buns is my $3.)  The grocery store uses those same $3 to pay the employee who put the buns on the shelf.  And so on. Thus, my initial $3 ends up creating an increase of more than $3 in GDP.

Obviously, the real word is more complicated.  Some of the $3 is taken out at each transaction in taxes, some of it is saved by various economic actors instead of spent, etc.  However, you can measure this effect.  The Congressional Budget Office generally calculates the multiplier for federal spending as a range between 0.5 and 2.5.  (Here is sample source,  but there are lots of CBO reports using the same numbers.) So this means that, in reality, the shutdown is costing the US economy anywhere between $150 million to $750 million a day in lost GDP.  In any event, the costs are almost certainly more than $300 million per day number that is being widely reported in the media.

Of course, this calculation doesn’t include the medium- and long-term savings we get for not borrowing nearly a third of that money to cover the deficit, but that is a different blog post entirely.